At the New York close, all three major U.S. indices had sizeable gains:

* The blue-chip Dow Jones Industrial Average Index soared 889.35 points, an increase of over 10%, to close at 9,065.12.
* The tech-laden Nasdaq Composite Index jumped 143.57 points, an increase of 9.5%, to reach 1,649.47.
* And the broader Standard & Poor’s 500 Index shot up 91.59 points, an increase of over 10%, to settle at 940.51.

“The valuations are extremely compelling right now,” Dan Veru, who helps manage about $2 billion at Palisade Capital Management in Fort Lee, New Jersey, told Bloomberg News. “When you’re in extreme oversold conditions, the market is prone to these types of wild swings. The key thing is, can we hold these gains?”

It was the second-biggest daily point gain for the blue-chip Dow, which had a record-setting 936-point one-day gain earlier this month.
With a “lack of selling pressure” late in the afternoon, “the buyers began to ride in on their horses, and that brought in some additional buyers and short-covering,” Robert Pavlik, chief investment officer at Oaktree Asset Management, told MarketWatch.

All sectors posted gains across the board with energy, up 11.76%, and basic materials, up 11.74%, marking the largest gains.

The Fed’s Federal Open Market Committee (FOMC) is expected to release its statement on monetary policy tomorrow (Wednesday) afternoon.

The Fed is widely expected to reduce its benchmark Federal Funds target rate as the likelihood of a U.S. recession continues to increase and inflation pressures have abated.

The Fed Funds rate currently stands at 1.50% and a cut of 25-50 basis points is expected.

“The cut is already in the market,” John Ryding, economist at RDQ Economics told AFP.

“The question is whether it’s 25 or 50 basis points.”

Source: Dow Zooms Above 9,000 on Eve of Expected Fed Rate Cut

The minutes of the last policymaking Federal Open Market Committee (FOMC) meeting, released on Wednesday, showed that the Fed’s inflation forecast was raised from a range of 2.1%-2.4% to a range of 3.1%-3.4%.

Add the zooming oil prices we have seen recently into the mix, and the conclusion is inevitable: The nation’s central bank will soon have to reverse course and start raising interest rates – and probably in a hurry, too, if the Fed wants to keep oil prices on this side of the stratosphere.

That’s no small shift: After all, for nearly eight months the central bank has been mounting one of the most aggressive rate-cutting campaigns on record, slashing the benchmark Federal Funds rate from 5.25% down to 2.0%.

The Key Catalysts

Several factors have made it imperative that rates head higher. Let’s take inflation first. The consumer price index (CPI) figures for the last couple of months actually have been encouraging for the market. CPI has been coming in lower than analysts had expected. However, in both March and April, the downward seasonal adjustment was huge, far above the average adjustment for the past 10 years.

Thus, in March, a price increase of 0.9% (equivalent to 11.1% per annum) was revised down by the magic of seasonal adjustment to a mere 0.3%. Similarly, in April, an unadjusted 0.6% figure was seasonally adjusted down to just 0.2%.

It doesn’t require a super suspicious person to find that odd, especially during a period in which everyone’s worried about inflation. If the average March and April seasonal adjustment for 1998-2007 had been applied to the unadjusted figures, the annual rate of inflation for March and April would have been above 7%, instead of the 3.1% officially reported.

In any case, the producer price index (PPI) inflation is running at 6.5%, which suggests the CPI figure could experience an uptick very soon.

Either way, if the Fed thinks inflation will be above 3%, and the monthly figures come in above that number – let alone as high as 6%-7% – it won’t be able to keep the Fed Funds rate at its current 2.0% for long. The FOMC knows quite well that a Fed Funds rate lower than the current inflation rate will only serve to fuel inflationary pressures, and force the inflation rate even higher. If the Fed thought inflation was at 2%, it could justify keeping the Federal Funds rate at 2%; but now that the FOMC has acknowledged that it thinks inflation will be above 3%, it’s difficult to justify such a low Federal Funds target – something around 3%-3.5% seems more plausible, even if the United States is fighting a recession.

If monthly inflation numbers were all the Fed was worried about, we could expect the central bank to gradually ratchet the Fed Funds rate up to about 3% – or perhaps even a little bit higher. This deft initiative might get under way at the FOMC’s June 24-25 meeting, or might start at its Aug. 5 meeting, but either way, short-term rates would reach 3% by the end of this year, unless the banking system suffered another real disaster before then.

However, the oil markets have given the Fed something else to worry about.

Oil prices at $133 per barrel last Wednesday were up 60% from the $83 per barrel level on Sept. 18, 2007, the day the Fed began easing cycle for interest rates [oil prices punched through the $135-per-barrel level on Thursday before sliding back]. Other commodity prices have also gone through the roof during that same period. While U.S. monetary policy isn’t the only thing affecting global oil prices, which are dollar-denominated, it’s pretty clear that the Fed rate cuts and the central bank’s creation of money through bailing out the banking system have made an awful lot of money available for oil speculators.

And while hedge funds and sovereign wealth funds are reaping these massive windfalls, don’t forget the flipside of this equation …

This pricing petro-gusher is costing the United States real money.

The Suicide Squeeze Play

Since the United States currently imports about 9.4 million barrels per day, the $50 price increase since September has cost the United States $470 million a day. That’s $170 billion per annum, more than 1% of gross domestic product (GDP), or 22% of the current U.S. balance of payments deficit.

T. Boone Pickens, the octogenarian Texas oil legend, has emerged with a prediction that the price of oil could reach $150 a barrel by the end of the year. He points out that the world oil supply is currently at a maximum of 85 million barrels per day, while demand is 87 million.

There’s just one problem. There’s no way this supply shortfall of just 2 million barrels per day, or 2.3%, should cause oil prices to soar 60% in eight months – let alone another 15% before year-end as Pickens predicts. Rising prices should reduce demand and (to a lesser extent) increase supply. Economists differ by how much, but no economist I know of thinks the price elasticity of oil is below 10%: And at 10% elasticity, a 2.4% supply shortfall should push the price up 24%, not 60%.

So where does the other 36% come from – not to mention the additional price increases that Pickens is predicting?

It must be “artificial” – that is, created by speculators.

With U.S. interest rates below the inflation rate, betting that oil prices will go up is like shooting fish in a barrel – you can’t miss, provided only that you and your friends are together rich enough to control the market. And with all the extra money that the Fed has created just sloshing around, speculators are nothing, if not rich.

How do you stop speculators? You whack them with a two-by-four, that’s how. You get their attention with a shock move. You bring them pain by increasing their financing cost, you insert in their mind the idea that you might really mean it, and underscore that you might go on attacking them until their speculative run-up in oil prices is ended.

Indeed, the interest-rate reduction could set in motion a series of diverse global events that will impact such seemingly unrelated areas as European inflation, global food prices, the U.S. dollar, American exports, and the already chilly relationship between the European Central Bank (ECB) and the government of France.

For any of this to happen, however, the Fed first has to act. Most observers believe the U.S. central bank’s policymaking Federal Open Market Committee (FOMC) will reduce the Federal Funds rate for the seventh time since mid-September, dropping the benchmark borrowing cost from 2.25% to 2.0%.

According to many experts, the Fed’s timing will be excellent. Economists have increasingly come to believe that the U.S. economy is probably in a recession already, although most await more-certain evidence before actually making the pronouncement.

Some of that evidence could come out today. U.S. stocks traded in a narrow range yesterday (Tuesday) as the market awaited two important announcements: The advance estimate of U.S. Gross Domestic Product (GDP) and the central bank’s rate-reduction decision – both due out today.

“Another large batch of companies has reported quarterly earnings results, but overall, they have failed to move the needle that much as the market is in a wait-and-see mode ahead of the GDP data and the FOMC decision on Wednesday,” Patrick O’Hare at Briefing.com Inc. told the AFP news service.

There are some strong dissenters.

“There is no reason why the Fed should be cutting rates right now,” Richard Yamarone, director of economic research at Argus Research Corp., told MarketWatch.com.

What Tales GDP Doth Tell

Although GDP is a lagging indicator, analysts anxiously await the report since it will demonstrate whether the U.S. economy is as weak as many believe. According to a Reuters‘ poll, first quarter GDP is expected to clock in at a sluggish 0.2%, down from a 0.6% growth rate in the fourth quarter. Reuters developed the consensus estimate by averaging 89 predictions, which ranged from contraction of 0.8% to growth of 1.5%.

Most analysts, including those at UBS AG (UBS) and Lehman Brothers Holdings Inc. (LEH), felt March’s surprisingly strong durable goods orders and an increase in inventories would tip the balance in favor of slim growth in the first quarter. However, analysts did note that inventory increase could signal weakness ahead, especially if not supported by the accompanying increase in sales needed to create the “sell through” that would keep additional inventories from piling up.

“A $5 billion accumulation of [inventories] would add almost a full percentage point to GDP growth and, in our forecast, constitutes the difference between a positive and a negative result,” RBS Greenwich Capital said in a note to clients.

A positive GDP estimate, however slight, could mean the U.S. economy is poised to skirt a true recession. The textbook definition of a recession is two consecutive quarters of negative GDP growth.

But the weak GDP estimate, which will be announced early this morning, could prove the justification the FOMC needs to recommend another rate reduction this afternoon.

CME Group Inc.’s (CME) Chicago Board of Trade futures are pricing in an 82% chance that the FOMC will recommend the U.S. Federal Reserve make a quarter point cut, bringing its key interest rate down to 2.0%. When the Ben S. Bernanke-led central bank started its rate-cutting campaign last year, the Fed Funds rate stood at 5.75%.

And if policymakers do order the rate-reduction, most analysts believe it will be the last one for awhile; those same CBOT futures indicate a 71% chance that the Fed will hold the line on interest rates when the committee meets again in June.

“The direction of Fed policy hangs in the balance, and there are people like me that hope the central bank quits sooner rather then later,” Jack A. Ablin, chief investment officer at Harris Private Bank, told The New York Times.

But here’s where the global wild cards come into play.

When Everything’s Wild

With its ambitious rate-cutting strategy, the Fed has stoked domestic inflationary pressures and helped accelerate the decline of an already-sinking dollar.

Officially, the U.S. inflation rate stands at about 4%, though many experts – including Money Morning Contributing Editor Martin Hutchinson – believe the actual U.S. inflation rate is much higher. In fact, anyone who studies the sharp increases in energy, food prices, commodities, healthcare, and a university-level education may find it tough to argue that prices aren’t headed higher.

Even with a bit of a rebound, of late, the dollar is down more than 7.3% against the euro in the past six months, 12.35% in the past 12 months and nearly 28% in the last 54 months. The greenback is down substantially against other key currencies, too, and that’s helped fuel a massive run-up in the cost of energy and food-related imports – all highly inflationary for U.S. consumers.

At the same time, however, the cheap dollar has made U.S. exports very competitive abroad. Indeed, for foreign buyers of such big-ticket products as Boeing Co. (BA) jetliners, the plunging dollar has served as a global blue-light special. Boeing’s bureaucratic arch-rival, Airbus SAS, hasn’t been able to compete, and a week ago was actually forced to raise prices on two of its commercial jets – citing rising steel prices and a falling dollar as the two key causes.

On Sunday, French Economy Minister Christine Lagarde said the gap between the U.S. and Eurozone interest rates was way too large, and called for a change in interest-rate policies – either by the Fed or the European Central Bank (ECB).

The U.S. Fed has been slashing rates to jump-start economic growth while also keeping a horrid housing market from putting the entire economy to sleep. The ECB, by contrast, has kept rates high to combat inflation – even though that strategy is pushing Europe into an undesirable slowdown.

“We are in a delicate situation where we have, on the one hand, an American Federal (Reserve) which has a policy of very low rates and a European Central Bank which has maintained high interest rates,” Lagarde told LCI Television and RTL Radio, the global wire service Reuters reported. “The differential in interest between the two, it seems to me, is a little too big at the moment.”

Paris has long been a vocal critic of what French President Nicolas Sarkozy has termed the ECB’s overly narrow focus on fighting inflation. But Sarkozy and Co. have been criticized by both Germany and the ECB for attempting to meddle in the business of a supposedly “independent” central bank.