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The conventional wisdom on Wall Street is that the Fed will continue with its own form of Chinese water torture. Only the terminally insane or the congenitally optimistic think that the Fed won’t continue raising short-term interest rates a quarter of a point every time it meets from now till the end of the year. Here are several reasons why the Fed may have a lot less to do this year when it comes to raising rates.


1. THE DOLLAR HAS STABILIZED.
The primary objective of Fed policy is price stability. A declining dollar makes that objective more difficult. Since the first of the year, the dollar has stabilized and actually risen modestly against the yen and more vigorously against the euro. After three years of decline, the fundamentals for the dollar are improving. U.S. growth is much stronger than anywhere else in the developed world, which attracts foreign investment. The trade deficit while still dismal is beginning to show signs of improvement. A rising dollar reduces the cost of imports and pressures domestic producers to hold the line on prices.

2. COMMODITY PRICES ARE DOWN.
Commodities are globally traded and almost always priced in dollars. A rising dollar increases the global non-dollar price, putting downward pressure on the dollar price. Commodity prices in general and the price of gold in particular are good leading indicators of inflation and overall financial system stability. Since peaking in late November of last year, gold prices have lost about $30 an ounce. Oil prices peaked in April and are down $10 a barrel from their $58 highs. The Commodity Research Bureau’s broad index of commodities has fluctuated widely for the past 18 months, but is roughly unchanged from January 2004.

3. THE WORST OF THE INFLATION NEWS IS BEHIND US.
With the dollar firm and commodity prices falling, the worst of the inflation news is now history. The price index for personal consumption expenditures alleged to be Chairman Greenspan’s favorite inflation indicator rose 2.6 percent in Q4 2004 but only 2.3 percent in Q1 2005.

4. THE JUNK BOND MARKET IS TRAUMATIZED, HEDGE FUNDS ARE HURTING.
During past periods of rising interest rates, the Fed has pushed rates up until it broke something. The financial turbulence that follows forces a halt in additional rate hikes. As interest rates rose in 1998, hedge funds took a pounding, which led to the bailout of Long Term Capital Management. And the last round of tightening took down the NASDAQ bubble. This time, the round of tightening has led to trauma in the junk bond market as yields have soared even as interest rates on higher-quality debt have remained unchanged. Rumors are also rife now that the recent market volatility in the junk bond market has resulted in large losses at different hedge funds. A failed hedge fund would be another sign that the Fed has gone far enough.

5. LONG RATES SHOW NO INFLATIONARY EXPECTATIONS.
While the Fed has been quite aggressive in pushing up short-term interest rates, long rates have actually come down. After eight rate hikes over the past year, 10-year treasury rates are 70 basis points lower. Long rates are very sensitive to changes in inflationary expectations. Traditionally, the yield on 10-year bonds will equal inflationary expectations plus three percent. With 10-year yields down around 4.1 percent, inflationary expectations are well below the current level of inflation.

Implications for Food Stores
An end to Fed tightening would be good news for U.S. consumers and food store operators. Food prices, which have shown some real strength in recent months, can be expected to moderate. A stronger dollar will put some downward pressure on the price of imported goods. Lower gasoline prices should also free up a little more discretionary income for mid- and low-income consumers.
An end to Fed tightening also suggests that the current business cycle, which is only three and half years old, still has a lot of life left in it. Plans for new store expansion can be kept with an expectation that the economy recovery still has some legs to it.

Implications for Convenience Stores
An end to Fed tightening would be good news for convenience store operators. A slow fall in gasoline prices is also generally positive for gasoline margins. Lower prices at the gas pump would also free up a little more discretionary income for better sales in the store.

Implications for Mass Merchandise Stores
An end to Fed tightening would be good news for mass merchant store operators. With interest rates still low, the housing boom can be expected to continue. A strong housing market traditionally drags along a lot of additional consumer spending in home-related categories.