With oil trading near a three-month low (and corn now at a four-month low), U.S. Federal Reserve policymakers may have just the ammunition they need to hold the line on interest rates for the foreseeable future – or at least until their Sept. 16 policymaking meeting.

On the other hand, threats of hurricanes in the Gulf of Mexico and geopolitical turmoil in Iraq, Turkey, Nigeria – and now the fireworks between Russia and Georgia – could spark a dramatic reversal in sentiment and renew fears of supply disruptions.

However, this week’s economic calendar contains the types of reports that will factor into the musings of Federal Reserve policymakers with regards to interest rates.

The report on the Consumer Price Index (CPI) for July – due out Thursday – gives economists another look into domestic price pressures, although the recent drop in energy prices will not yet be reflected in this data.  Then again, economists tend to focus only on so-called "core" inflation (which "excludes volatile food-and-energy prices," anyway).

The July retail sales report gives us some additional insight into the consumer mindset, demonstrating that those tax rebates are virtually all gone. With gas prices on the decline, consumers should have a bit more available disposable income in the months ahead (though, again, the July numbers may not show any enhanced activity just yet).

Additional confirmation of the recent consumer cautiousness should come from the next round of earnings reports, which will feature reports from such retailers as Macy’s Inc. (M), J.C. Penney Co. Inc. (JCP), Nordstrom Inc. (JWN), and Wal-Mart Stores Inc. (WMT).  Should the gas trend continue, consumers could emerge from hibernation just in time for the holiday shopping season… wishful thinking? 

Market Matters

Let the games begin. As host of the 2008 Summer Olympic Games, Mainland China takes center stage and gets the chance to show the rest of the world that it has arrived as a global player and an economic superpower. Of course, no event should be more apolitical than the Olympics.  That is, until China banned some participants for their support of Darfur.  And before U.S. President George W. Bush criticized China’s poor record of human rights on the eve of the games. And before China deported a few activists who were demonstrating against certain national policies. (Probably nothing that a few gold medals won’t cure.)

Speaking of having politics cross over into the economy: Last week, Democratic presidential candidate Barack Obama publicly lobbied for the sale of 70 million barrels of oil from the U.S. strategic reserve and also claimed to now support new offshore drilling (if his tire gauge idea fails to prove an effective policy).  As the presidential-election campaigns accelerate into the home stretch, investors can expect plenty of promises (and flip-flopping) from both sides of the aisle.  (How do you feel about those Bush tax cuts this week, Senator McCain?) 

So just where are investors to turn these days?  Freddie Mac (FRE) and Fannie Mae (FNM) returned to the headlines last week, as both reported significant losses – far in excess of Wall Street expectations.  (Weren’t those analysts following the news?)  Likewise, insurance giant American International Group Inc. (AIG) reported its third consecutive quarterly loss as its mortgage portfolio remained deeply under water.  Citigroup Inc. (C), Merrill Lynch & Co. Inc. (MER) and UBS AG (UBS) each reached multi-billion settlements with the New York state attorney general over certain high-risk securities that the firms will buy back from affected investors. Outside of financials, Cisco Systems Inc. (CSCO) – the subject of a recent "Buy, Sell or Hold" feature in Money Morning – provided a boost to techs by announcing better-than-expected profits; likewise, The Procter & Gamble Co. (PG) proved that consumer companies could still thrive, despite surging commodity prices.
 
Institutional funds have garnered additional interest as of late as investors seek out non-traditional asset classes to help compensate for the challenges of the markets.  In July, Hedge Fund Research Inc. reported that the return on a basket of 60 funds designed to reflect the industry as a whole declined by about 3%, the worst monthly showing in six years.  Tutor Investment Corp. will be spinning off its Raptor fund at year-end after bad calls on the energy sector caused ongoing losses for the past two years.  Private equity firm, Fortress Investment Group LLC (FIG), reported a larger-than-expected quarterly loss and has seen its share price drop about 40% since its IPO in early 2007.  Bear in mind, not all hedge funds and non-traditional assets are created equal; plenty of "winners" have emerged lately.

Anyone remember when oil touched $147 a barrel on July 11?  Has the bubble officially burst?  Energy continued its downward spiral as oil fell below $117 barrel, its lowest level since early May.  Rising inventories eased supply/demand concerns and renewed strength in the dollar also helped support domestic securities (thanks to the European Central Bank – see below).  Equity market volatility remained as investors tried to weigh the negative Freddie/Fannie reports against the positive energy trend (and the inactivity of Federal Reserve policymakers with regards to interest rates – also see below). Stocks alternatively soared, plunged, and soared again as the major indexes moved considerably higher by end of last week.

Then there are the ongoing Beijing Summer Olympic Games (which opened Friday), a reminder that every investor should have a China investment strategy [Editor's Note: Please click here to read the first part of our two-part research report -"Why Every Investor Should Have a China Investment Strategy." The second part of that report will appear later this week.]

Perhaps that jubilant Olympic spirit is contagious?  So let the games continue: "USA…USA…USA…!"

Economically Speaking

They came, they debated, they analyzed, and they left – with no action taken. The "they" we refer to here are the members of the Federal Open Market Committee (FOMC), the Federal Reserve policymakers responsible for setting interest rates.

With dueling economic dilemmas impacting the country (slow growth vs. inflation), Federal Reserve Chairman Ben S. Bernanke and his band of central bank policymakers chose to leave the benchmark Federal Funds rate unchanged at 2.00% at their policymaking meeting last week.

While most Fed-watchers still expect the next interest-rate move to be to the upside, some believe such an action is unlikely before the end of this year as reduced consumer activity continues to spark talks of recession.  The recent decline in commodity prices helped the Fed stay on the sidelines, given that inflationary pressures are slightly less than before (at least, for the time being).  The European Central Bank (ECB) and Bank of England both left their key rates unchanged as they also weigh ongoing economic concerns in their countries against continued price pressures.  They prompted a surge in the dollar and took additional pressure off of the Fed, as well. 

On the retail front, same store sales in July were lackluster at best as consumer held off on back-to-school purchases and focused on necessities such as food and household goods. (Apparently, last year’s No. 2 pencils and lunchboxes still will work fine.

Even the afore-mentioned Wal-Mart’s sales came in slightly below expectations while mall chains – the Limited Brands Inc. (LTD) and The Gap Inc. (GPS) – and luxury retailers such as Saks Inc. (SKS) all struggled as consumers no longer had those tax rebates to spend.  Moving to housing, the Federal Deposit Insurance Corp. (FDIC) reported that just under 1% of all prime (not subprime) loans originated in early 2007 were at least 90 days delinquent, meaning that the mortgage crisis still has a ways to go before being resolved (and additional write-downs may be on the way).  The weekly jobless claims data showed that more unemployed folks are seeking government benefits than at any time since March 2002.

Weekly Economic Calendar

News and Related Story Links:

• Beijing Olympic Games:
  Home Page.

• Money Morning News:
  ECB Holds Rates Steady, but Growth Concerns are Beginning to Supplant Fears About Inflation.

• Money Morning Special Investment Report:
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• Wikipedia:
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• Money Morning News Analysis:
  Cisco Says "No Deal" for EMC; Shares Jump on Better-Than-Expected Financial Results.

• Money Morning News:
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• FDIC.gov:
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• Money Morning Global Investing Roundups:
  Weekly Jobless Claims.

Federal Reserve policymakers yesterday (Tuesday) kept the nation’s benchmark interest rate at 2.00% for the second consecutive meeting, although inflation accelerated and the U.S. economy only advanced slowly.

"Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the committee," the policymaking Federal Open Market Committee (FOMC) said in a statement.

After a slight contraction in the fourth quarter of 2007, U.S. gross domestic product (GDP) has expanded at a moderate pace, enabling the U.S. economy to dodge an actual recession. GDP increased a 1.9% annual rate in the second quarter after edging up 0.9% in the first quarter. Consumer spending, which accounts for about 70% of GDP, rose 1.5% in the April-June period after a 0.9% jump in the first quarter.

However, those gains were largely the result of the $112.4 million in stimulus payments sent out this spring, and analysts wonder if spending will hold up under as unemployment continues to rise and high prices stretch household budgets.

"My view is that the Fed is on hold at least through the fall and likely" even longer than that, said Joel L. Naroff, president and chief economist of Naroff Economic Advisors Inc. in Holland, Pa. "The worries about inflation notwithstanding, the FOMC still started with a discussion of the economy the comments were not particularly sanguine. The committee is likely to need some hard data that conditions are getting better before they start to unwind the rate cuts. With payroll declines continuing, it is hard right now to see how that could happen by year’s end."

The Fed began its historic rate-cutting campaign on Sept. 18, when it slashed the Fed Funds rate by half a percentage point, bringing it down to 4.75%. That ignited the biggest one-day stock-market gain in five years, with the Dow Jones Industrial Average soaring 336 points to close at 13,739.39.

The 30-stock blue-chip index soared 331.62 points yesterday to close at 11,615.77. At that level, the Dow is down 19% from its high-water mark of last year – technically just outside the 20% boundary that denotes an official "bear market."

The U.S. unemployment rate hit 5.7% in July – its highest level in four years. 

"Labor markets have softened further and financial markets remain under considerable stress," the Fed’s statement said. "Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters."

With jobs clearly being "a central concern," Naroff said investors should "watch the employment data carefully. A reappearance of job gains could change the outlook quickly."

Of course, inflation has risen to its highest level in 17 years, led by higher food and energy costs, leaving the Fed with little or no room to cut rates if the economy does falter. The U.S. Federal Reserve’s preferred gauge of inflation rose at a 2.1% pace in the second quarter, down only modestly from 2.3% in the three prior months.

"Inflation has been high, spurred by earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated," the Fed said.

Inflation is already putting the squeeze on the American consumer. In current dollars, consumer spending rose 0.6% in June. But after adjusting for inflation, spending actually dropped 0.2%. The development is a harsh indication that U.S. shoppers are paying more to get less.

Dallas Fed President Richard Fisher was the only dissenting opinion in a 10-1 vote to leave hold rates steady, preferring instead to raise rates immediately. Fisher is widely regarded by Fed watchers as the most hawkish of the current Fed policy committee members.

News and Related Story Links:

• New York Times:
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• Money Morning:
  What to do When the Federal Reserve Finally Gets Serious about Inflation

• Money Morning:
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• Money Morning:
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• Federal Reserve:
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• Money Morning News:
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Every market cycle has its genius.

Even a market cycle as wild and volatile as this one has been.

And the latest genius might be just what the U.S. Federal Reserve needs to restore order around here: She might even be able to bring credibility back to the global financial markets.

Elizabeth Duke goes by "Patsy." And while the nickname may be soft, the person behind the moniker isn’t soft. In fact, we believe that Patsy Duke – a career commercial banker – is the only Federal Reserve insider that understands how the global money markets actually work.

As such, she might just be the next central bank chairman.

We say that because, unlike current Fed Chairman Ben S. Bernanke and the rest of the Beltway Boys – all of them academic theoreticians, data experts, or policy wonks – Duke has real commercial banking experience.

A Real "Find" at the Federal Reserve

Over the last 32 years, Duke worked her way up from the teller’s window, where she started, to an executive vice president’s post at Wachovia Corp. (WB). Along the way, she also became the first woman to chair the American Bankers Association – no small feat, considering how much of an "Old Boy" industry banking has always been.

Duke actually understands the consequences – what will happen – when you hand out $37.5 billion in taxpayer-subsidized freebies a week like the Federal Reserve is doing right now. And as the only commercial banker on the Fed’s governing board, she’s literally the only one with a firm grasp on the key regulatory issues the central bank should be addressing.

We realize that whenever someone hears the word "regulatory," there’s an almost-unstoppable urge to yawn, followed by the desire to surf the Web for last night’s West Coast baseball scores.

But don’t be so quick to forget that the seeds of the current global financial crisis were sown by the almost-complete breakdown of mortgage-lending standards and banking-industry oversight – some of which can be laid right at the feet of the arrogant theoreticians who thought they knew better and who viewed the borrowing public (read that to mean consumers like you and me) as merely a bunch of numbers.

In the interest of realism, let me say right now that for Patsy Duke to be given the Federal Reserve’s scepter, she’s clearly got a long line of hurdles to clear. But we’re hoping that she does.

As Money Morning readers know very well, I believe that Team Bernanke fishtailed badly as it tried to get up to speed on the subprime mortgage mess, turning what could have been a very clean race into the Global Garbage Grand Prix. And the central bank’s weak-dollar policies have the potential to hurt the U.S. economy for years to come.

The Financial Backdrop Facing the Fed

From a global perspective, fears of an ever-worsening contagion finally seem to be subsiding even if a weak housing market, a badly outdated regulatory system, and increasingly illiquid funds and still more write downs suggest the risk of a sharp economic pullback or even a recession are still extant. But those are the very types of insidious financial nightmares we’re hoping Duke’s influence and experience will help prevent.

None of this eradicates the inflationary pressures we’re all feeling right now.

But the chances are very good that Duke is the first Federal Reserve governor who understands, on a personal level, just how hard it is to make ends meet when the economy slows down, inflation takes hold, and investors get pinched.

Of course, none of this really matters unless the markets turn around. But when it comes to the Fed, the distinction of having a single, real-world executive included in its ranks will help it restore confidence, and perhaps even fix the financial markets before they get any worse.

News and Related Story Links:

• Wikipedia:
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Citing the risk of high inflation, the U.S. Federal Reserve voted to hold the Federal Funds rate steady at 2.0% yesterday (Wednesday).

"Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased," the accompanying Federal Open Market Committee (FOMC) statement read.

The statement did not allude to any future rate hikes at the next FOMC meetings scheduled for August or September. It was a very balanced statement overall, acknowledging the dual threats of stagnation and inflation currently facing the U.S. economy.

"It is more or less a neutral statement, which is consistent with policy on hold pending more clarity," James O’Sullivan, a senior economist at UBS Securities LLC in Stamford, Conn., told Bloomberg News. "They are not tipping their hand for the next meeting."

There’s no clear-cut course of action before the Fed, as its Chairman Ben S. Bernanke and the other FOMC members must carefully weigh the dual threats of stagnation and inflation facing the U.S. economy.

Skirting Stagnation

Gross domestic product growth clocked in at 0.9% for the first quarter, an increase from the 0.6% GDP growth in the last three months of 2007.

But several recent economic reports show the U.S. economy remains sluggish at best, and consumer sentiment is at a record low. Unemployment climbed 0.5% in May to 5.5%. The housing market continues to suffer and drag on other sectors, while some areas of the credit markets remain near frozen.

"Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters," the FOMC statement read.

The Fed must execute caution, as a hasty switch in tactics could do more harm than good, as it seems clear economic recovery is far from a certainty at this point.

"The Fed is going to need to start hiking interest rates at some point to start to deal with inflation," Matt King, chief investment strategist with Bell Investment Advisors in Oakland, Calif., told Reuters. "That’s a bigger risk than recession."

Battling Inflation

Commodity prices are soaring with oil over $135 per barrel and food costs are escalating global hunger problems. Even excluding the volatile costs of food and energy, the so-called "core" consumer price index is running at a 2.3% annual clip, above the Fed’s desired 2.0% inflation target.

"The Committee expects inflation to moderate later this year and next year," the statement read. "However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high."

Many have called upon the FOMC to raise rates in order to battle inflation. At least one Federal Reserve Bank president remains concerned inflation, rather than slow economic growth, is the more dire threat. Richard Fisher, president of the Federal Reserve Bank of Dallas, dissented on today’s monetary policy decision, voting instead for a rate hike. Fisher also voted against lowering rates at the last two FOMC meetings.

Things could get ugly if Bernanke chooses not to follow through on his recent position against inflation and in favor of strengthening the dollar.

"Unless the inflation expectations and the numbers come down, they’re going to have to raise rates," William Ford, a former Atlanta Fed chief who’s now at Middle Tennessee State University in Murfreesboro, said in a Bloomberg Radio interview before the decision. "If [Bernanke's] saying we’re going to fight inflation but he’s all bark and no bite, division is what’s going to happen."

Bernanke’s counterpart across the Atlantic, European Central Bank (ECB) President Jean-Claude Trichet has publicly proclaimed inflation his top priority and has even gone so far as to suggest the possibility of a 25-basis point ECB rate increase as early as July.

But many feel a single rate increase won’t be enough in the 15-country Eurozone, where inflation reached 3.7% last month, well-above the central bank’s 2.0% target rate.

"There is disagreement among ECB policy makers about the future course of monetary policy, but one increase will simply not be enough," Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group PLC (ADR: RBS) in London, told Bloomberg. "At the end of the day, inflation concerns will rule."

News and Related Story Links:

• Money Morning:

Waiting for the Fed’s Decision, Statement

• U.S. Federal Reserve Website:

Federal Open Market Committee Statement

• Bloomberg News:
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• MarketWatch:
  Fed sharpens focus on inflation

• Bloomberg News:
  Investors Call ECB’s Bluff, Bet on Rate Increases

Economists and investors wait with bated breath for the U.S. Federal Reserve to release the statement from the Federal Open Market Committee this afternoon (Wednesday) at 2:15 p.m. EDT.

While it is almost universally expected that the FOMC will vote to hold the Federal Funds rate steady at its current 2.0%, the language in the accompanying statement will be scrutinized for clues about the upcoming August and September meetings.

In a recent Bloomberg News survey, all 101 economists queried expect the Fed to pause on any further rate actions for the time being. Many believe there will be no movement in the key interest rate until mid-2009 at the earliest.

But traders have a different view, as demonstrated by Fed Funds futures traded on the Chicago Board of Trade. Those futures are predicting very slim odds of a rate change tomorrow, but are currently pricing in a 36% chance of a rate hike at the FOMC’s August meeting and 93% odds of a rate hike in September.

Recent comments by Fed Chairman Ben S. Bernanke have helped boost traders’ expectations of a reverse in course after one of the most aggressive rate-cutting campaigns in recent history slashed the Fed Funds rate 325 basis points from 5.25% last September.

But there’s no clear-cut course of action before the Fed, as the FOMC must carefully weigh the dual threats of stagnation and inflation that are now facing the U.S. economy.

Holding Steady

It’s true that commodity prices are soaring with oil over $135 per barrel and food costs causing an escalation of global hunger problems. Even excluding the volatile costs of food and energy, the so-called "core" consumer price index is running at a 2.3% annual clip, above the Fed’s desired 2.0% inflation target. That would seem to point to a rate increase as the obvious choice.

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But several recent economic reports show the U.S. economy remains sluggish at best, and consumer sentiment is at a record low. Unemployment is on the rise at 5.5% in May. The housing market continues to suffer and be a drag on other sectors of the economy, while some areas of the credit markets remain near frozen.

"We think the U.S. economy is still too fragile for a rate hike and thus expect the Fed to stay on hold – this time and also during the next meeting," Harm Bandholz, an economist for UniCredit, wrote in a note to clients, Reuters reported.

The Fed must execute caution, as a hasty switch in tactics could do more harm than good. Economic recovery is far from a certainty at this point.

"That’s the dangerous game," Scott Anderson, senior economist in Minneapolis at Wells Fargo & Co. (WFC), the fourth-largest U.S. bank by market value, told Bloomberg News. "Instead of putting the shot across the bow on inflation," Bernanke might have "held off a few more months to let the credit crisis heal a little bit more."

Raising Rates

At least two Federal Reserve Bank presidents are more concerned with inflation than slow economic growth. Richard Fisher, president of the Federal Reserve Bank of Dallas, and Charles Plosser, president of the Federal Reserve Bank of Philadelphia, both voted against lowering rates at the last two FOMC meetings.

Things could get ugly if Bernanke chooses not to follow through on his recent position against inflation and in favor of strengthening the dollar.

"Unless the inflation expectations and the numbers come down, they’re going to have to raise rates," William Ford, a former Atlanta Fed chief who’s now at Middle Tennessee State University in Murfreesboro, said in a Bloomberg Radio interview. "If [Bernanke's] saying we’re going to fight inflation but he’s all bark and no bite, division is what’s going to happen."

A dissent this time around, when a vote to hold rates steady is expected, would be a very hawkish sign as it would mean Fisher and Plosser are willing to raise rates in order to stave off further inflation.

Bernanke’s counterpart across the Atlantic, European Central Bank (ECB) President Jean-Claude Trichet has publicly proclaimed inflation his top priority and has even gone so far as to suggest the possibility of an ECB rate increase as early as July, which would only serve to further strengthen the euro against the struggling greenback.

Propping Up the Dollar

Currency traders are looking for a statement that alludes to future rate increases in order to prop up the buying power of a weak dollar.

"There’s no real belief that we’ll see a rate hike, but it’s the accompanying comments that will provide the most meaningful direction, and a hawkish tone could easily see the greenback lock in the latest gains on a more permanent basis," James Hughes, currency strategist at CMC Capital Markets, told MarketWatch.

The dollar traded in a narrow range ahead of the FOMC decision. The dollar index, which measures the green back against a basket of six major foreign currencies, was down slightly with a 0.3% decline in late afternoon trading.

"Even if the dollar/yen were to go down after the FOMC meeting in reaction to what they say in the statement, I think the downside of the dollar is limited," Satoru Ogasawara, foreign-exchange analyst and economist at Credit Suisse Group AG (ADR: CS) in Tokyo, told MarketWatch.

"There is now the perception that the U.S. doesn’t want the dollar to weaken," Ogasawara added.

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Throughout history, governments have always used crises to justify blatant power grabs.  All too often, the "expanded government powers" that resulted from the moves remain in place – even after the crisis subsides.

This tendency has come into sharp focus here in America recently. Congress signaled that it is preparing to perpetuate the Bush Administration’s domestic wiretapping program, and has even abandoned the pretense that warrantless surveillance be confined to terrorism. 

Similarly, even though our financial crisis has yet to reach full flower, U.S. Treasury Secretary Henry M. Paulson has announced plans to give the U.S. Federal Reserve new and explicit powers to oversee and regulate the financial services industry.  However, a sober look at his plan reveals that it is tantamount to giving the fox complete autonomy to guard the henhouse.

What few economic leaders have acknowledged is that the Fed itself is responsible for the real estate and credit bubbles that are the source of our current troubles.  By keeping interest rates too low for too long, the U.S. central bank itself ignited a speculative fever and engendered a disregard for risk management that pushed asset prices above rational levels.  Should we blame the private sector for taking advantage of all the cheap credit, or the Fed for supplying it?  If a kindergarten teacher passes out handfuls of Pixie Stix, and then leaves her classroom unattended for several hours, should we blame the five year olds for the sugar-jag-induced hysteria that ensues? 

The reality is that we should be restricting – rather than expanding – the powers given to the Federal Reserve.  Since former Chairman Alan Greenspan, current Chairman Ben S. Bernanke and the rest have inflicted so much damage with the weapons already in their arsenal, why provide them with still-heavier artillery?  Only in Washington do those who screw up get rewarded for doing so. 

Since the Fed has demonstrated complete incompetence at setting interest rates, why not return that function to the market?  Instead of allowing the Fed to inflict unbridled havoc on our economy, why not re-impose some discipline?  Instead of looking for new ways to regulate Wall Street, why not find an old way to regulate the Fed?  Actually there is a simple answer to all of these questions; it’s called the gold standard.

In his speech outlining these proposals, Paulson stated that during the past 50 years, the performance of the U.S. economy has been second to none.  I do not know what planet Paulson has been living on these past 50 years, but it certainly wasn’t Earth.  If Paulson had been referring to the prior 50-year period, from 1908-1958, his statement would have been correct.  But from 1958 to 2008, the U.S. economy has blown a lead even greater than the one the Los Angeles Lakers enjoyed over the Boston Celtics in Game Four of the just-concluded NBA Finals.  In fact, it may well qualify as the biggest economic choke in history.

In 1958 the United States enjoyed a standard of living so unmatched that the rest of the world still lived in the Stone Age by comparison.  Our per-capita income was so far ahead of our nearest rival that it seemed impossible that any other nation would ever catch up. 

Today, not only is the per-capita income in the United States barely in the Top 10, but countries that up until a few years ago were barely discernable in our rear-view mirrors are rapidly overtaking us.  When it comes to economic performance during the past 150 years, the United States is the Big Brown of economies.  The period from1858-1908 was the Kentucky Derby, while 1908-1958 was the Preakness Stakes, and 1958-2008 was the Belmont Stakes. The United States dominated the first two, but lost the final round.

Indeed, not only did the United States surrender a substantial lead, but in many respects our current standard of living is lower than the one our grandparents enjoyed.  Sure we have a few more gadgets, larger televisions and more prevalent air conditioning, but the quality of life has actually declined. 

In the 1950s, the average man earned enough money to fully support a wife and four kids, all while saving for retirement and paying off his mortgage.  Today the average man can barely support himself.  It takes two breadwinners in most families to make ends meet, and that is assuming there are only two children.  Even with both parents working, the typical mortgage on the family home will never be paid off and retirement is now a pipedream.  Flush with high pay, low debt, and a strong currency, the Ugly American in the 1950s could vacation in Europe like a king.  Now we can barely afford the gas for a day trip to a Six Flags theme park.

If Paulson can be so completely clueless regarding the Fed’s role in the current debacle – and in America’s economic stumbles during the past two generations – why should anyone place any faith in his proposed remedies?  In fact, a Federal Reserve that’s not elected and that’s accountable to no one – and which nonetheless has lately proven to be as politically craven as any two-bit politician – does not hold the keys to our economic revival.  However, with its increased willingness to rescue the big financial firms from their own excesses, perhaps Paulson sees an expanded Fed as the best way to ensure the continued prosperity of his former pals on Wall Street. 

[Editor's Note: Peter D. Schiff, Euro Pacific Capital Inc.'s president and chief global strategist, is a regular contributor to Money Morning, and most recently wrote about the fallacy of the Fed's "strong dollar policy" in his most recent Money Morning column. For a more-detailed analysis of the nation's financial problems, and the inherent dangers that these problems pose for both the U.S. economy and for dollar-denominated investments, click here to download Euro Pacific's new financial-research report, "The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities." The report is free of charge.]

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• Wikipedia:
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• CBS.sportsline.com:
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The U.S. Federal Reserve will be in the spotlight again this week – and not because of those speaking engagements that seem to help whipsaw investor emotions. Tomorrow (Tuesday) and Wednesday, central bank Chairman Ben S. Bernanke will meet with his fellow policymakers on the interest-rate setting Federal Open Market Committee (FOMC).

After one of the most aggressive rate-cutting campaigns in its history – a stretch that’s seen the Fed pare its benchmark Federal Funds rate from 5.25% in mid-September all the way down to 2.0% today – most experts believe the central bank’s next move will be to take interest rates higher to blunt inflation. But few of these Fed-watchers are willing to predict that the increase will be made now, or even in August, although the interest-rate-futures market is projecting such a possibility. (Money Morning Contributing Editor Martin Hutchinson – an international-banking expert – predicted that reversal in policy well ahead of the masses, and says the move needs to be made sooner rather than later – if inflation is to be blunted).

After all, while "recession" may be off the table for the time being, the most recent economic releases point to continued sluggishness and higher rates could prove devastating to future growth.  Investors will await the Fed’s accompanying statement, scrutinizing the text for clues about the central bank’s view of inflation, and how it sees the escalation of food-and-energy prices feeding into overall prices [For a more-detailed analysis of the Federal Reserve's actions, check out this related story in today's issue of Money Morning].

The consumer will play a major supporting role in this saga again this week with the release of several key reports that should provide some added insights into the mindset of the U.S. consumer.

Why should we care? Simple. The U.S. consumer is responsible for two-thirds of the country’s economic activity, so investors should be quite interested in the latest confidence index reading and statistics on personal spending and income. 

In the eternal optimist corner, some investors will ask (or, more accurately, hope) that this will be the week that the housing releases (new and existing home sales) reveal that an upcoming sector rebound is on the horizon?

But as we’ve been saying since last fall, don’t expect to see that turnaround anytime, soon.

Market Matters

Up until now, the central bank has been able to concentrate on so-called "core" inflation, which (as the tagline says) "ignores volatile food-and-energy prices." That strategy was acceptable in the past – in fact, it even worked well – because food-and-energy prices were somewhat erratic from month to month. So the focus on "core" inflation enabled the central bank to concentrate on what was "really" happening with the economy.

But that’s no longer an effective strategy. Indeed, by ignoring food-and-energy prices, the central bank is actually ignoring what’s "really happening" out in the marketplace.

Who says it’s all about the "core" price data?  While much of the recent inflation focus has been on soaring oil and gasoline, the devastating Iowa floods have brought rising food prices right to the forefront of the current market debate.

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Though feed prices have been climbing for the past few years, corn has surged more than 10% during the last two weeks, leaving farmers and meat producers worried about the appetites of those already "belt-tightening" consumers. Some blame the ethanol mandates for the shrinking grain supply and are turning to politicos for relief.

Meanwhile, crude futures encountered a volatile week last week as traders analyzed the contrasting news from aboard.  On one hand, the news that Saudi Arabia may be increasing oil production and that China is hiking gasoline and diesel fuel prices should dampen demand and move prices lower. On the other hand, Israel threatened Iran’s nuclear facilities and rebels reportedly attacked a Chevron Corp. (CVX) plant in Nigeria late last week (both of which should contribute to higher oil prices).  For now, crude stands around the $135 per barrel level. 

Despite his low popularity rating, President George Bush has yet to relinquish the limelight as he blamed the Democratic Congress for the record gas prices.  Playing his own political game, President Bush proposed lifting the ban on drilling in certain environmentally friendly regions, knowing full well that such an idea will be met with great resistance.  He also acknowledged that such measures would have little impact on the current state of the energy sector as new drilling would take years to implement and even longer to generate any real results.

Lehman Brothers Holdings Inc. (LEH) announced a startling $2.8 billion loss in the second quarter, its first since going public, though the company avoided (for now) becoming the next Bear Stearns Cos. Inc. (BSC) by raising $6 billion in new capital.  Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) both reported declining earnings, though each bested The Street’s already dire expectations.

Rumors have Merrill Lynch & Co. Inc. (MER) and Citigroup Inc. (C) taking more write-downs, negating prior speculation that the worst of the credit crisis had ended. That speculation resurfaces on a fairly regular basis, and whenever it does, we’ve emphatically told Money Morning readers to ignore it. Our view was supported this week over in Europe when analysts at Royal Bank of Scotland Group PLC (RBS) said looming write-offs would cause a global stock-market crash by September.

In non-financial corporate news last week, FedEx Corp. (FDX) reported a quarterly loss and projected a pretty negative outlook for 2009 due to soaring fuel costs.  After its snubbing by Yahoo! Inc. (YHOO), Microsoft Corp. (MSFT) denied any interest in other Internet acquisitions at this time.  Continental Airlines Inc. (CAL) and UAL Corp. (UAUA) (United Airlines) are teaming up in a "non-merger" alliance to help create new revenue sources and cost efficiencies without the risks and red-tape of a full-fledged transaction. 

In the "misery-loves-company" category, the global markets struggled mightily last week as the Shanghai Composite Index fell to a 16-month low and has declined about 50% on a year-to-date basis.  Likewise, indexes in Tokyo, Bangkok, and Hong Kong have followed suit.

Here at home, the Dow Jones Industrial Index plunged below 12,000 for the first time in more than three months, as rising food and energy prices and ongoing negativity from financials continued to weigh on investors.  Bonds, which had come under pressure lately over future Fed policy, were the recipients of a flight-to-quality mentality as some investors sought the safe haven of the Treasury markets. For the time being, however, it’s all about those skyrocketing food and energy prices.

But then again, don’t economists always downplay "volatile food-and-energy prices" as they tell us to focus on so-called "core" inflation?

Economically Speaking

And The Survey Says…The Business Roundtable released results from its recent poll that showed corporate executives believe the economy will grow at a 1.3% pace in the year’s second quarter (up from 0.9% in the 1st quarter, but still reflective of ongoing sluggishness).  While expectations have declined from the March survey when the trade group reported projected growth of 1.5%, the results seem to reveal that the executives’ concerns about the dreaded "R" word have subsided – at least for now.

Meanwhile, more than 30% of CEOs surveyed believe that their companies will feel a labor pinch in the form of layoffs (or perhaps attrition) over the next six months. 

On the inflation front, the producer price index (PPI) surged by 1.4% in May, its largest increase since last November.  Further, the most recent surge in oil prices and the impact of the floods in the Midwest on food prices have yet to be reflected in this wholesale price gauge.  Fortunately, economists like to focus more on the core (ex-food and energy) data, which only climbed 0.2% in May.  (Apparently, the volatile food and energy prices are just as likely to fall as they are to rise, so they really shouldn’t be counted…if only that were true, these days). The housing sector continued to struggle as May construction starts plunged to the lowest level in 17 years.  Additionally, the manufacturing sector suffered a setback, with industrial production for May depicting an output decline in the nation’s factories, mills and mines.

Weekly Economic Calendar

News and Related Story Links:

• Money Morning Financial Analysis:
  Corn Prices Linger at Record Highs but Wheat and Rice Wear Thin.

• Money Morning Financial Analysis:
  Dallas Fed President Lends Credibility to Money Morning’s Prediction That the Federal Reserve Will Soon be Boosting Interest Rates.

• Money Morning Financial Commentary:
  Saudi Arabia’s Promise to Open the Oil Spigot is Nothing But Spin.

• Money Morning News:
  Oil Drops as China Ratchets Up Fuel Costs.

• CNNMoney.com:
  Nigeria Rebel Group MEND: Chevron Oil Facility Attacked.

• Money Morning Financial Analysis:
  Financial Fears Sweep the Globe After RBS Predicts Worldwide Stock-Market Crash.

The U.S. Federal Reserve faces a tough challenge as it kicks off a two-day policymaking meeting tomorrow (Tuesday): It probably needs to start raising interest rates to prop up the U.S. dollar and offset a major escalation in inflationary pressures; but the economy needs low interest rates if it’s to maintain its anemic growth rate.

After one of the Fed’s most aggressive rate-cutting campaigns ever slashed short-term interest rates from 5.25% in mid-September to 2.0% now, experts now expect the central bank to reverse course. And this week’s two-day meeting of the policymaking Federal Open Market Committee (FOMC) represents the first chance for the central bank to boost its benchmark Federal Funds rate.

Recent hawkish comments by central bank Chairman Ben S. Bernanke had led some analysts to expect a 25-basis point rate increase at this meeting, but front page stories in both The Wall Street Journal and The Financial Times are detailing softened expectations.

The odds of an increase have fallen: Fed Funds futures traded on the Chicago Board of Trade are pricing in a 10% chance of an increase in this overnight lending rate. Any announcement will likely be made at the conclusion of the FOMC meeting on Wednesday. Prior to the recent news stories, the odds were about 22%. Odds of a rate increase at the FOMC’s August meeting also fell.

Investors also will be interested in the accompanying FOMC statement that will be released around 2:15 p.m. EDT on Wednesday.

The statement after the last FOMC meeting acknowledged inflation concerns, but maintained that economic growth was still the top priority. A more-balanced statement is expected this time around as commodity prices continue to soar and oil recently flirted with a new high of $140 per barrel.

Many analysts have called for interest rate increases to stem inflation and prop up a weak greenback, which only serves to fuel the increases in dollar-denominated commodities such as oil. The dollar dropped last week against all major currencies, according to Bloomberg data, falling to $1.562 against the euro on Friday.

"The re-emergence of financial concern places a question mark on the Fed’s ability to raise interest rates," Matthew Strauss, a senior currency strategist in Toronto at RBC Capital Markets Inc., a unit of Canada’s biggest bank Royal Bank of Canada (RY), told Bloomberg News.

Referring to the April 22 high of  $1.6019, Strauss said that "the possibility of a revisit to $1.60 is still in the cards."

Even if the volatile costs of food and fuel are excluded, the current consumer price index (CPI) is at 2.3%, above the Fed’s 2.0% inflation target.

Recovery Far from Certain

Inflation has grabbed most of the recent headlines, but the weak economy continues to be a concern.

The U.S. economy continues to sputter along without a true contraction, but gross domestic product (GDP) growth has been far from robust at just 0.9% for the first quarter. The subprime mortgage crisis that first began around this time last year with the implosion of two Bear Stearns Cos. Inc. (BSC) hedge funds (whose managers were recently indicted), continues to take a toll on both the financial and housing industries.

Separate government reports recently showed that housing starts hit a 17-year low while the producer price index (PPI) jumped 1.4% in May.

"We will not likely see the next action, rate hikes, until late in this year at the earliest," Joel Naroff, president and chief economist at Naroff Economic Advisors, wrote in a note to clients. "The housing and industrial production data released [last week] do not tell us the economy has stabilized to the point where the Fed would have any cover to raise rates."

And if a recent report from analysts at the Royal Bank of Scotland Group PLC (ADR: RBS) is correct, an economic recovery remains in the distant future.

RBS analysts have warned clients to brace for a full-blown crash in the global stock-and-bond markets in the next three months, as the conflicting realities of slowing growth and rising inflation paralyze the world’s major central banks – causing "all the chickens [to] come home to roost," Great Britain’s Daily Telegraph newspaper reported.

The predicted swoon would cause the U.S. Standard & Poor’s 500 Index – already down 16% from its trading high of 1,576.09 reached Oct. 11 – to nosedive all the way down to 1,050 by September. For the closely watched, broad-based U.S. stock index, that would represent an additional decline of 20% from Friday’s close of 1,317.93- and a total decline of 33% from its Oct. 11 apex.

At the same time, lending standards remain tight and many sectors of the credit market are nearly frozen, despite the aggressive rate-cutting campaign by the Fed that has brought the key interest rate down to 2.00% from its high of 5.25% last September.

The spread between the London Interbank Offer Rate (LIBOR) and the Fed Funds rate remains wide, as the three-month LIBOR was at 2.80% on Friday, according to MarketWatch data. Banks are still gun shy about lending, as major houses continue to take multi-billion dollar write-downs on mortgage-backed securities and other high-risk assets.

As long as the LIBOR rate is so much above Fed Funds, the U.S. central bank will unlikely tighten, William O’Donnell, U.S. government bond strategist at UBS Securities (UBS), told MarketWatch.

"There are still credit issues out there and LIBOR is an unsecured rate," O’Donnell said. "Banks don’t want to lend to each other when it’s unsecured. Risks to growth are very high. Very clearly, the Fed is trapped in a vise." [For a related story on the U.S. Federal Reserve and recent economic developments, check out this related story in today's issue of Money Morning.]

News and Related Story Links:

• Bloomberg News:
  Dollar Heads for Weekly Decline on Pared Bets Fed to Raise Rate

• MarketWatch:
  Five reasons the Fed won’t raise interest rates

• Reuters:
  Policy-makers weigh stronger Fed role on Wall Street

• BusinessWeek:
  Vital Signs: What Will the Fed Say Now?

• Barron’s:
  Will The FOMC Take The Fork In The Road?

• Money Morning:
  Stagflation Worries Loom as Inflation Soars and Housing Remains Weak

• Money Morning:
  Financial Fears Sweep the Globe After RBS Predicts Worldwide Stock-Market Crash

By William Patalon III
Executive Editor
Money Morning/The Money Map Report

Just one day after Money Morning predicted that the U.S. Federal Reserve would soon be forced to increase interest rates, Dallas Fed President Richard W. Fisher said he expected the central bank would raise interest rates should inflationary pressures start causing severe consumer pain.

“If inflationary developments and, more important, inflation expectations continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic" U.S. economy, Fisher said during a Wednesday speech in San Francisco.

In a financial commentary titled, “With Oil Speculators Blitzing, the Fed Needs to Call an Interest-Rate Reverse Play,” Money Morning Contributing Editor Martin Hutchinson predicted that escalating inflationary pressures will force central bank policymakers to start increasing the benchmark Federal Funds rate – perhaps as soon as the two-day Federal Open Market Committee (FOMC) meeting that’s scheduled for June 24-25.

Although the article was datelined Wednesday, Money Morning’s articles are typically posted to the Web site the night before. And Hutchinson actually filed the article on May 21 – a full week before Fisher made his comments. Even before that, however, Hutchinson has repeatedly warned that inflation was becoming problematic: Back in early April, he even predicted that gold prices are headed for the $1,500-an-ounce level – again, due to inflationary pressures [Check out several of Hutchinson's recent inflation-related research reports - one detailing profit plays stemming from higher oil prices, and the other looking at gold plays. Both reports are free of charge].

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A move to boost interest rates would be a major story as well as a major turnabout for the U.S. central bank. After all, for nearly eight months the Federal Reserve has been engaged in one of the most aggressive rate-cutting campaigns in its history, having slashed short-term interest rates from the 5.25% level in mid-September down to 2.0% today.

The Fed Funds rate is the interest rate Fed-member banks charge for overnight loans to other institutions needing the cash to meet reserve requirements. Changes in that rate quickly affect borrowing costs throughout the U.S. economy, since commercial lenders are quick to adjust the so-called “Prime Rate” – and rates on other types of loans – in lockstep with changes in the Fed Funds rate.

Hutchinson, a longtime international banker and an expert on emerging-markets finance, said that as soon as he read the minutes from the April 29-30 FOMC meeting, he knew a near-term rate increase was likely. The two key reasons:

• The central bank had reduced its 2008 economic growth outlook from the range of 1.3% to 2.0% it issued back in January down to a new, lower 2008 growth estimate of 0.3% to 1.2%.
• At the same time, FOMC policymakers boosted their estimates for inflation – excluding food and energy prices – to a range of 2.2% to 2.4% this year, up from an earlier range of 2.0% to 2.2%.

According to Hutchinson, that double-whammy of lower growth and higher inflation leads to only one conclusion: Interest rates must head higher.

“Obviously, the Fed’s outlook on growth and inflation both changed,” Hutchinson said in a telephone interview from his Washington-area home yesterday. “There’s a lot of straw in the wind at this point.”

The April FOMC meeting minutes were released May 21; Hutchinson wrote his analysis and made his predictions later that same day. Prior to the release of the Fed minutes, there was almost no marketplace expectation of a near-term increase in interest rates.

Over the past few weeks, several other Fed bank presidents – including Thomas Hoenig of Kansas City and Gary Stern of Minneapolis – have displayed an escalating concern about spiraling pricing pressures. But Fisher, 59, is the only FOMC policymaker to “dissent” three times from decisions to lower the Fed Funds rate, Bloomberg News reported.

Fisher either wanted to see less-aggressive actions, or no changes at all to interest rates.

“I don’t know a single person on the committee that isn’t concerned about inflation,” Fisher told reporters immediately following his Wednesday speech to the Commonwealth Club of California. “The question is, ‘what is the right treatment? That is subject to debate.’”

In his speech, Fisher said he expects the Fed will raise rates should the public expectations of higher prices begin to surge. And the combination of higher inflation and slower growth bodes poorly for the U.S. economy.

U.S. consumers are “in for a period of anemic economic activity [that probably will last] for awhile,” Fisher told journalists after the speech. And then when the economy quickens, the U.S. may be “encumbered by a higher rate of inflation than we ordinarily would like to have.”

According to the April Fed meeting minutes, most FOMC members viewed last month’s rate cut as a “close call.” Along with Fisher, the meeting records show that Philadelphia Fed President Charles Plosser wanted the central bank to stand pat on rates, citing the “more worrisome development” in inflation.

Going forward, Money Morning’s Hutchinson says one additional recent development further buttresses his prediction of an interest-rate increase by the Fed: On Wednesday, Federal Reserve governor Frederic Mishkin announced that he’s leaving the central bank Aug. 31 to return to teaching at Columbia University’s Graduate School of Business. A member of the Fed’s board of governors since Sept. 5, 2006, Mishkin was part of the “soft money crowd,” who advocated lower rates, and who might therefore oppose a move to raise them anew, Hutchinson says.

Given that, Hutchinson says that a Fed Funds increase of a quarter to a half-percentage point is possible at one of the next two meetings – the one in June, or the next one in August.

Futures traders expect the Fed to hold off on further rate cuts this summer, and to start raising rates in the fall. Futures contracts price in a 4% chance of an additional rate cut when the Fed meets in late June and a 56% chance that FOMC policymakers will opt to boost the Fed Funds rate by a quarter point to 2.25% when they meet in late October, MarketWatch.com reported.

Despite the shift in expectations among institutional investors, a continued escalation in crude oil and gasoline prices has kept alive the threat of inflation.

Needless to say, Money Morning will continue to watch market changes, and will keep you informed of our expectations.

News and Related Story Links:

• Money Morning Financial Commentary:
  With Oil Speculators Blitzing, the Fed Needs to Call an Interest-Rate Reverse Play.

• Bloomberg News:
  Fed Should Increase Rates If Inflation Accelerates, Fisher Says.

• The Federal Reserve Bank of Dallas:
  Storms on the Horizon: Remarks before the Commonwealth Club of California (in) San Francisco, California, May 28,2008.

• Bloomberg News:
  Federal Reserve minutes indicate further interest rate cuts are unlikely.

• MarketWatch.com:
  Fed governor Mishkin resigns effective Aug. 31.

• Money Morning Special Investment Research Report:
  Six Ways to Play Money Morning’s Prediction That Gold is Headed for $1,500 an Ounce.

• Money Morning Special Investment Research Report:
  As Oil Prices Hit Another Record High, Consider These Three Ways to Profit From This Long-Term Gusher.

• MarketWatch.com:
  Fed’s Fisher sees rate shift even if growth weakens.

The U.S. markets surged yesterday (Thursday) the day after the U.S. Federal Reserve came though with the broadly expected 25-basis point rate cut that brought the fed funds rate down to 2.0%.

The blue-chip Dow Jones Industrial Average Index gained 189.87 points (1.48%), to trade at 13,010.00. The tech-laden Nasdaq Composite Index shot up 67.91 points (2.81%), to reach 2,480.71. And the broader Standard & Poor’s 500 Index increased 23.75 points (1.71%), to close at 1,409.34.

"The economic data wasn’t that bad, the inflation data is certainly not well over the Fed’s target, so you could consider that a relatively good sign," Robert Pavlik, chief investment officer at Oaktree Asset Management, told MarketWatch. "There’s a bit of volatility on continued reaction to the Fed’s statement; the market is trying to come to an agreement that the Fed is on a pause, and was hoping for more of an indication that a pause would be in effect."

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But some industry experts feel the Fed’s language was clear and to expect a pause on further rate cuts.

Bob Doll, global chief investment officer of global equities at money manager BlackRock Inc. (BLK), told Reuters that the Fed is most likely done with its series of interest-rate cuts that began in September, as financial market conditions are improving and economic growth isn’t deteriorating as some speculated.

"They are going to watch everything, but I think the fact that the two-year note and Fed funds are not far from one another tells us that they might be done," Doll added.

A host of lackluster economic indicators were announced yesterday, but the market seemed to take them in stride.

Initial jobless claims increased by 35,000 to a four-week high of 380,000 for the week ended April 26. Many sectors are seeing layoffs and hiring freezes as business investment declines and the worst housing slump in a generation continues unabated.

In a separate report, the U.S. Commerce Department announced that consumer spending increased 0.4% in March, mostly due to higher consumer prices. Without the effect of inflation on the price of goods and services, consumer spending increased just 0.1%.

The Institute for Supply Management reported manufacturing activity contracted again in April, while the Commerce Department said construction spending dropped 1.1% in March.

Good news came from across the pond, as the Bank of England released its semi-annual report on financial stability, which signaled the worst of the credit crisis could be over.

In the accompanying statement, John Gieve, a Bank of England deputy governor, said the pricing of risk in credit markets appears "to have swung from being unsustainably low last summer to being temporarily too high relative to fundamentals," MarketWatch reported.

"So, while there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months," Gieve said.

News and Related Story Links:

• Bloomberg News:
  U.S. Unemployment Benefit Rolls Climb to 4-Year High

• Reuters:
  BlackRock’s Doll sees end of Fed cuts

• MarketWatch:
  U.S. stocks higher in following technology advance

• MarketWatch:
  Worst of credit crisis may be over: Bank of England