Why Fed's Easy Money Policy Is 'Straining Credulity'

The Federal Reserve's promises to keep its monetary policy loose may be upended by higher oil prices, which threaten to push U.S. inflation to unsustainable levels, analysts said.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

Although growth is not likely to be much above 2 percent in the first quarter of the year, "the US economy seems to be progressing nicely," ING analyst Rob Carnell wrote in a market note, but warned about the threat posed to inflation by higher oil prices.

"That said, the Fed’s commitment to keeping policy unchanged, or even easier for the next two years, is straining credulity," he said. "Bond yields have crept up only fractionally so far, but are at risk of further increases if inflation remains high, and if economic growth manages to shrug off the effect of higher gasoline prices."

Consumer price inflation came in at 0.4 percent in February, in line with expectations by analysts surveyed by Briefing.com and higher than 0.2 percent in January. Core inflation - excluding volatile fuel and food prices - was a modest 0.1 percent month-on-month.

Year-on-year, overall consumer prices advanced by 2.9 percent while core prices increased by 2.2 percent.

"We don’t expect this to be the peak for core inflation, and our models suggest a further increase, taking it to somewhere in the 2.7-2.8 percent area before it begins to level off. So today’s dip marks nothing more than a pause before further core inflation increases," Carnell said in commentaries after the release of the figures.

Another analyst, Derek Halpenny, European head of Global Currency Research at Bank of Tokyo Mitsubishi UFJ, pointed to a recent statement by the president of the Richmond Fed, Jeffrey Lacker, that higher rates will be needed sooner than the 2014 mark announced by Fed Chairman Ben Bernanke.

"Fed hawk Lacker mentioned yesterday why he dissented and repeated that rates may well have to rise in 2013, something the markets are now moving toward," Halpenny wrote in a market note, adding that this meant the euro's rate against the dollar was "vulnerable to the downside."

Price Pressures

ING's Carnell argues that the U.S. is "one of the most exposed economies to higher private vehicle fuel prices," explaining that the country has one of the highest weights of car fuel in its Consumer Price Index basket compared with other countries, low indirect taxes on gasoline and no potential to appreciate its currency to cushion the effect of oil price rises, as crude is already priced in dollars.

"The US is also more exposed to any potential knock to stock markets following an oil price shock, given relatively wide share ownership," he added.

Analysts told CNBC on Thursday that the bull market in U.S. bonds was finally coming to an end because of worries over a rise in inflation which will force the Fed to break its promise of easy money until 2014.

An improving jobs market, a stronger dollar and rising commodity prices are adding to pricing pressures on everyday goods, the analysts said.

However, not all analysts agree, with some saying that inflation was still a long way from rising on a sustained basis.

Capital Economics analysts wrote in a market report that CPI is likely to fall back towards 2 percent by the end of the year.

"We also suspect that oil prices are close to a peak. Indeed, reports of discussions between the US and the UK over a possible release of official stocks have already helped to undermine Brent on Thursday," the analysts wrote.

"What’s more, even if the oil price does rise further, the most likely catalyst would be a supply shock due to the tensions with Iran that ultimately would dampen economic growth and result in lower inflation than otherwise," they added.