Fed will remain paused at Wednesday, September 20, 2006 FOMC meeting and stay on course with 5.25% for the rest of the year and next

It has only been barely over a month since the Fed "changed course" by pausing their long rate hiking campaign, but already this "pause" is beginning to sound like a broken record.

The dramatic decline in crude oil and gasoline prices in recent weeks virtually guarantees that the Fed will continue the pause at the FOMC meeting on Wednesday, September 20, 2006.

As of Friday, Fed funds futures continued to firmly predict that the Fed will remain paused at 5.25% at their September 20, 2006 meeting. October Fed funds futures predict a rate of 5.2600%, or about a 4% chance of a hike and a 96% chance of no hike. Sure, that could change at a moment's notice, but for now is a rather solid, slam-dunk, no-brainer for a continued pause in September.

November Fed funds futures predict a rate of 5.2800%, suggesting only a 12% chance of a hike to 5.50% through November or an 88% chance of no hike. January futures predict a rate of 5.2900%, suggesting a 16% chance of a hike or an 84% chance of no hike. And the odds decline from there. Note that futures less than 45 days out tend to have some chance of accuracy, but further out futures are susceptible to very wild swings and changes in market sentiment and frequently reflect insurance hedges rather than outight bets.

People were chattering less about the chance for a rate cut in interest rates sometime in 2007, with futures suggesting no chance of a cut through February, a 24% chance of a cut to 5.00% in March or April, and an 80% chance of a cut through July, but these may be more of an insurance hedge rather than outright bets.

My estimates are very rough calculations based on Fed funds futures prices. More accurate modeling of fed funds rate predictions based on options on federal funds futures can be found on the the Cleveland Federal Reserve Bank's web page for Fed Funds Rate Predictions. Based on their calculations from Thursday, there is an 92% probability of 5.25% after the September meeting, and an 82% probability of a 5.25% rate after the October meeting. I'm sure that their sophisticated modeling and math is far more rigorous than mine, but the final number is still in the same ballpark and still has the same overall message: no hike at either the September or October FOMC meetings.

My unchanged view is that although the Fed has a strong preference for inflation in the 1% to 2% range, even the 3% range is somewhat tolerable, at least for a a relatively short span of months or maybe even a year. Oil prices are well off their recent peak. Ditto for gasoline. Speculators are still bullish on commodities, but overall, commodities prices have lost much of their upward momentum.

Make no mistake, the Fed would dearly love to push inflation down below 3% or even 2.5%, but by the same token they will not go very far out on the limb to do so.

It may take a number of months or even an entire year for inflation to pull comfortably back into even the low 2% to 3% range, but the Fed has in fact done all of the heavy lifting and now has the luxury of sitting back and watching the fruits of its labors gradually take root.

We saw some moderation of inflation in August and now a huge pullback in energy prices over the past few weeks, suggesting that the inflation reports for the next couple of months should show a trend in the Fed's direction. We won't be out of the woods by any measure before the end of the year since the price level for energy is still high and still pushing costs up throughout the economy, even if that level is trending down.

General points:

• The economy has slowed enough that additional hikes are not clearly needed.
• The economy is still strong enough that another hike won't kill it or send it "spiraling" into recession.
• The economy is also strong enough that some further hikes could be needed a few more months down the road.
• The economy has a lot more underlying strength than a lot of pundits give it credit for.
• The housing "boom" has certainly waned, but even a moderate softening of the housing sector is not going to lead to a general recession.
• Inflation is likely to start trending down (called disinflation) over the coming months.

For now, energy prices are no longer a large red flag on the inflation outlook. They are still a large yellow flag, but as long as the price of crude oil stays below $75 and unleaded regular gasoline stays below $2.75, the Fed will likely choose to "wait and see".

The hurricane season has been very mild this year to date. You can be sure that traders and speculators and planners will be hyper-alert for storm-related news, so we might not see crude oil futures pull back significantly further until we get well into October. We could also see one or more "technical" pullbacks based of technical analysis by traders and speculators, but they tend to be following by matching rallies, until we finally see an economically-based decline.

Although much has been made about a presumed 1% to 2% "inflation target" for the Fed, the reality is that 2% to 3% is about "as good as it gets" for the kind of economy and financial system we currently have in America. Sub-2% inflation does in fact occur on occasion, but only in a fleeting manner. Bernanke also made clear during his confirmation hearings that he was inclined to stick with the status quo for now and move towards specific inflation targets only over time. So, don't worry about such a target this year and probably even next year.

My impression is that once the Fed pauses for several meetinsg and considers monetary policy to be "stable", it will be prepared to "hold its fire" if monetary policy is roughly "neutral" (i.e., in the 4.5% to 5.75% range) and one-year inflation doesn't pop too far above 3%. That begs the question of which measure of inflation to use, but in truth it doesn't matter a whole lot. If you want to use headline inflation rather than core inflation, then you simply need to expand the range moderately (say, from 3% to 4.5%) to reflect the nature of volatility due to short-term pricing spikes (e.g., gasoline) that occur no matter what the state of the economy.

Before the August FOMC meeting it was not clear whether Bernanke would lean more heavily in the hawkish inflation-fighting direction or in the more dovish growth-promotion direction. The pause at the August FOMC meeting made it abundantly clear that despite being serious about fighting inflation, he prefers to protect growth. Put another way, he probably despises inflation a little less than he despises deflation.

Another factor that cannot be overlooked is that this is an election year, and there is a tendency (but not a hard rule) that the Fed should "lighten up" going into a politically-charged election season and avoid appearing to be helping one party or the other. I personally don't think that this was a major factor in the Fed's thinking or will be in the next two months, but this factor is out there.

My view is that the Fed will keep their fed funds target rate paused at 5.25% for at least the rest of the year, and probably for the entire coming year.

It is also my view that there will not be a recession next year, nor even enough of a growth slump to trigger a Fed rate cut.

Upcoming Fed FOMC meetings:

• September 20, 2006
• October 24/25, 2006
• December 12, 2006
• January 30/31, 2007

-- Jack Krupansky