Will the Fed fiddle while inflation burns?
February 07, 2011
First, the good news. Treasury yields soared last week, with 10-year bonds breaking above 3.6 percent for the first time in about nine months.
With financial markets setting interest rates higher, it should ultimately have a positive impact on savings accounts, money market accounts, and CDs. Those rates tend to be a little stickier than market rates--that is, since they are at the discretion of bank executives who aren't eager to raise rates right now, they won't respond as quickly as freely-traded market rates like bond yields. Eventually, though, a significant shift in the interest rate environment would trickle through to CD, savings, and money market rates.
After all, if banks are very slow to act, conservative investors will see increasingly attractive alternatives in bond yields, and banks will face an exodus of deposits unless bank rates become more competitive.
The threat from inflation
Now the bad news. The jump in bond yields can be traced in large part to growing concern over inflation. Copper recently reached an all-time high, and commodity prices generally are rising as global economic activity heats up.
This puts hopes for a rise in CD, savings, and money market rates in a different context. It's no longer a potential benefit for depositors, but merely something that will have to happen just to keep pace with inflation.
What will the Fed make of all this?
Meanwhile, one might well wonder what the Federal Reserve makes of all this. Their read of the economic situation seems very different from what the financial markets are reflecting. The markets are expressing optimism about growth, with concern about inflation. By continuing its low interest rate policies, the fed seems to be stuck on pessimism about growth and turning a blind eye to inflation.
If nothing else, the markets seem to be thwarting the Fed's "quantitative easing" policy, designed to drive Treasury yields down. Even so, the Fed has yet to change its tune. It's not unusual for the Fed to follow rather than lead the financial markets; however, with inflation starting to percolate, it's important that the Fed not lag too far behind.