Investors reaping the rewards of low interest rates should prepare themselves for a reversal of fortune.
The Fed’s moves to cut rates — now down to 2 percent in its latest action from 5.25 percent eight months ago — are over, and rate hikes to stop raging inflation could soon follow, predicts Kansas City Fed President Thomas Hoenig.
"Some would dismiss these rising inflationary pressures as temporary,” he said. "I believe they are more serious.”
The U.S. annualized inflation rate hit 4 percent in March. Energy prices rose by 17 percent, transportation by 8.2 percent and food by 4.5 percent.
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A slowing U.S. economy, and potentially a slowing China as a result, could slow inflation naturally, presuming the price of oil falls, too. But the traditional solution is to put less money into the economy, and that means the Fed must raise rates.
"There is significant risk that higher inflation will become embedded in the economy and require significant monetary policy tightening to reduce it,” Hoenig told the Economic Club of Colorado in Denver in a speech.
Hoenig said policymakers must be prepared to do the unthinkable — start hiking rates. The economy cannot recover if inflation continues to increase, he said.
Rising prices on fuel, food and other commodities are "more serious” than some critics believe, increases that mirror those of the 1970s and early ’80s, he said.
Hoenig sees even more inflation on the horizon. He places some blame on "imported” inflation due to rising labor and materials costs abroad — essentially, foreign economies are getting strong, and that’s where the products we buy are made — and on the weak dollar.
Hoenig is positive on the U.S. economic outlook, however. Markets are stabilizing, he says, and the economy should see a rebound in the second half of the year, plus the $152 billion tax rebate stimulus will have had an effect by then.
"Although credit conditions have tightened considerably in recent months and some markets for asset-backed securities have shut down, we have not seen as large a credit crunch as some anticipated,” Hoenig said.
"Despite current difficulties, in my view there is room for optimism about the near-term outlook for the U.S. economy.”
Hoenig believes the slowdown will be "short-lived” because of tax cuts, lower interest rates, and increasing U.S. exports. Prices for food and gas are expected to start to drop, leading to a decline in inflation.
"As the economy recovers and credit conditions improve, however, it will be necessary for the Federal Reserve to remove the policy accommodation in a timely manner. How fast this occurs will depend on whether inflation pressures moderate or intensify in the period ahead,” he warned.
Regulatory changes also must take place in order for the U.S. to avoid a future recession from abuses in lending markets, Hoenig said.
"There are many challenges ahead, many choices to make,” he said. "Some I suspect will be desperately unpopular.”
© NewsMax 2008. All rights reserved.
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