Should the Fed keep interest rates low? Yes, say bankers and oilmen

With the Fed Funds rate officially set in a range between zero and 0.25 percent, the only direction for them to go is up. But when the Federal Reserve will actually raise interest rates remains an open question. A stock-market rally that seems to foretell an economic recovery has been clashing with weak fundamental data, placing the Fed's policy under more scrutiny of late. Prices for oil and gasoline have increased dramatically since the start of the year, worrying some that the first signs of inflation from fiscal and monetary stimulus are at hand.

A Bureau of Labor Statistics release this morning showed that the Consumer Price Index has declined 1.3 percent in the last year, the largest drop since 1950. On a month-over-month seasonally adjusted basis, the CPI rose 0.1% after being flat the prior month. A similar BLS release of the Producer Price Index showed a 5 percent decrease year-over-year in the cost of finished goods. In May, the PPI was 0.2 percent higher compared to April, on a seasonally adjusted basis.

With unemployment approaching 10 percent and record levels of manufacturing capacity sitting idle, the Fed must judiciously balance raising rates to control inflation with leaving rates low to spur growth. Even with rates near zero, the Fed can use further "quantitative easing" -- printing money -- to restore lending activity. At the end of late August, total outstanding Federal Reserve credit stood at $891 billion, an amount that had held fairly steady; that amount, according to the Fed's latest disclosure, now stands at more than $2 trillion.

A Bloomberg survey shows that the majority of government bond dealers believe the Fed will wait at least one more year before increasing rates. In addition to tepid CPI and PPI numbers, two other datapoints may justify no action: weak fundamentals for oil, and bank balance sheets.

In a conversation with DailyFinance last week, Ann Kohler, managing director of Caris & Co., said the run-up in oil prices was a speculative move based on inflation concerns, but that in reality, the "fundamentals for oil are extremely weak." Oil prices have since fallen back to under $70 per barrel, and gas prices fell sharply today after an inventory report showed that supply levels were much higher than anticipated.

The Fed's interest rates also greatly impact banks, which are set to close out their books for the quarter at the end of June. Extremely low short-term rates have helped banks acquire and retain deposits at a very low cost, boosting profits and helping to quietly recapitalize the financial system. Bank of America (BAC), for example, paid $2 billion less in interest on its deposits in the first quarter of 2009 than it did in the first quarter of 2008.

Others were not so optimistic that the Fed would make the correct action. "I think zero is the wrong rate for almost any economy," Jim Grant of Grant's Interest Rate Observer said in recent days on CNBC. "The Fed has embarked on a vast experiment in moral hazard." Grant also worries that the Federal Reserve's historical pattern of being late to change rates will repeat itself: "Bernanke has shown a willingness to print money and a reluctance to tighten."

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