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(1) What do we see happening with inflation?
(2) In light of this, what do we think the fed should/should not do?
(3) What are the implications for the 2 yr and 10 yr t-bond?
My two cents (Anna Dev): If you look at the current environment, there is both slowing growth and cost pressures. Right now there is inflationary pressure coming from rising food and energy prices. However, Core CPI rose by 2.3% since last year (which isn't extremely high) and unemployment is actually higher than expected, coming in at 5.5% rather than 5.1%. One can argue that there is cost-push inflation which is coupled with concerns about a possible recession, leading to concerns about possible stagflation. Yet, I believe concerns of slowing growth are more prominent than current rising inflationary pressures. There is more reason to worry about a recession at this time than pricing pressures. In light of recent employment numbers, the tight credit market (which reduces consumers ability to borrow and will curb spending in the future) and the high volatility in the stock market, investors have shifted away from high risk assets to treasury bonds. People are worried about market conditions. I believe that the FED should not change the Fed Funds Rate. The FOMC should vote to keep the rate at 2.0%. First of, the rate is already at 2.0%, which means if the economy does head for a severe downturn, the Fed won't have much room to decrease the rate and would have to use alternative instruments, which they have already started to do (discount window to investment banks). In the next few months, the 2 yr bond yield and the 10 yr yield will fall as investors shift towards less risky assets. The treasury market overall will probably do well as a result of this action and the yield curve will steepen as shorter term bond yields fall more than yields at the end of the curve.
More (Inessa): I agree with most of what Anna said. Because growth is slowing I would recommend that the Fed keep rates as they are. However, inflation does pose a real threat. Until now producers have been able to keep from passing inflation through to consumers. In times of economic difficulty they won't be able to continue doing this and we will see rising energy costs begin to have a real effect on the prices of core consumer goods. This means that the Fed should begin raising rates sooner than they would have otherwise. This will most probably fall within the next two years. Therefore the prices of the 2 yr and 10 yr bonds should rise as we see energy prices soar.
Adding on (Sabina Sayeed) Agree with both Anna and Inessa. The economy, especially given the recent rise in unemployment figures, is too weak at this point for the FED to start raising the overnight lending rate above 2.0%. Inflationary pressures are obviously present and rising food and energy costs are taking a toll on consumer spending, but I think we need to see more signs of recovery (or at least, stability) in weak sectors such as the housing markets before we can consider raising the rate. Like Anna mentioned, current market conditions have caused investors to move towards less risky treasury bonds and I expect this market to do well in the coming months, and the 2 yr bond yield to fall more than the 10 yr bond yield.