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| Dr. William Poole, President Federal Reserve Bank of St. Louis |
On Wednesday, the publication of consumer price data and the minutes of the end of January rate setting meeting of the Federal Reserve, fanned fears that stagflation may be on the horizon- a slowing or contracting economy coincident with rising inflationary pressures. In related news, the impact of the credit crisis intensified in corporate debt markets, with default insurance rates hitting new highs.
The US Labor Department reported that consumer prices in the US jumped 0.4% in January and are up 4.3% over the past 12 months - close to a 16-year high. The so-called "core" rate - excluding rising food and energy costs - rose 0.3% in January, driven by education, medical care, clothing and hotels. The rate is up by 2.5% from the previous year, a 10-month high.
Federal Reserve Bank of St. Louis President William Poole said on Wednesday that excessive cuts in interest rates aimed at averting a recession run the risk of accelerating inflation to an ``unacceptable'' level.
``Taking out insurance against certain risks is not free,'' Poole said in a speech at Truman State University in Kirksville, Missouri. ``At any given time, policy makers could pursue a powerfully expansionary policy to all but eliminate the possibility of a significant recession in the year ahead, but doing so would come at the cost and even likelihood of an unacceptable increase in the rate of inflation.''
The Federal Reserve disclosed in minutes of its January meeting that its policymakers lowered their forecast for economic growth this year to between 1.3% and 2%, half a percentage point below the level of their previous forecast, in October. They said thata further slowdown in housing prices, tighter lending standards and higher oil prices, prompted the move. They also warned the economy's performance could fall short of even that lowered outlook.
In the minutes of the January 29-30 meeting, some members of the rate-setting Federal Open Market Committee (FOMC) noted it was important not to lose sight of controlling inflation. They argued that "when prospects for growth had improved, a reversal of [some rate cuts], possibly even a rapid reversal, might be appropriate."
However, it was also noted that keeping interest rates low "appeared appropriate for a time," implying Fed officials felt little urgency to reverse recent cuts. Even after the January meeting's half-point rate cut, to 3%, "downside risks" to the economy remain, they said.
Governor Poole said in his speech on inflation: "Could it be that there are now trends in place in the relative prices of food and energy? I am not prepared to dismiss this possibility. Rapid economic development in China and India has placed increased demand on the world capacity to produce both food and energy and therefore has surely contributed to the persistent gap between core and headline inflation numbers observed over the past five years.
It is not unreasonable to forecast that increased demand for food and energy by emerging economies with large populations will continue for a considerable period. This possibility suggests the FOMC must exercise caution lest monetary policy inadvertently accommodate an increased inflation trend by focusing on the behavior of price indexes excluding food and energy."
Corporate debt market turmoil
The Financial Times reports today that credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs.
The sharp jump, which rivalled the sell-off at the height of last summer’s credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.
The FT says that the sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered.
The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20% to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.
This means buyers of protection through so-called credit default swaps are paying €126,500 ($185,780) annually to insure €10m worth of debt over five years.
In the US, the situation was just as bad with the investment grade CDX index hitting a record wide of 165.5bp in morning trade – more than double its level at the start of the year.
The Wall Street Journal says today, that on Wednesday, the credit crisis hit two national retailers: San Francisco-based Sharper Image, which sells high-tech gadgets such as air purifiers and massage chairs, and Lillian Vernon Corp., which sells low-cost gifts such as Easter baskets and welcome mats. Both filed for federal Chapter 11 bankruptcy protection.
The Journal says that the mounting woes of the banks that supply corporate capital are contributing to the crisis. "The banks really don't know what kind of room they have to add new loans for companies until [the banks] fill the hole on their nonperforming loans," including mortgages, credit-card debt and auto loans that are souring, says Henry Miller, chairman of Miller Buckfire, a financial restructuring firm. "The dominoes have started to fall."
Corporate defaults and bankruptcies have risen sharply this year. The total value of corporate-bond defaults is already approaching the total for all of 2007. Moody's Investors Service now lists 41 companies it considers to be at risk of violating terms of their loan agreements, compared with 25 at the end of last June.
