Inflation control - US Federal Reserve

John Mauldin - Wed 08 Jun, 2005

"The US Federal Reserve is in an extraordinarily difficult position...Inflation control is formost...Some very distinguished observers believe the US Federal Reserve should stop their tightening cycle now. Others think that not only should they keep hiking interest rates at a measured pace...Raising interest rates too much or too little each bring their own set of problems..."

The US Federal Reserve is in an extraordinarily difficult position. Some very distinguished observers believe the Fed should stop their tightening cycle now. Others think that not only should they keep hiking interest rates at a measured pace, they should continue to do so for the rest of the year, for a variety of reasons.

Raising interest rates too much or too little each bring their own set of problems. But it is not altogether clear what the appropriate level of short-term dollar interest rates should be. Even if we found that appropriate level, it is not clear that the results would be what was first intended.

Indulge me for a few paragraphs, while I use a golf analogy. The technology of golf clubs has improved over the years. But every club, whether a hundred years old or fresh off the shelf, has one thing in common. They have been designed with a "sweet spot". The sweet spot is that point on the clubface that if you hit it square the ball will fly straight and true. Every golfer has had that moment of sublime bliss when he catches the ball just perfectly. There is something about a 250-yard down-the-middle drive that is simply good for the soul. Unfortunately, for most golfers, those are rare events.

The pros, who hit tens of thousands of practice balls a year, regularly find the sweet spot. The rest of us just struggle, but every now and then we hit the shot that brings us back to the golf course the next week. But hitting the sweet spot doesn't necessarily guarantee a positive outcome.

Now what does that have to do with the US Fed? They are like an amateur golfer who is down in the valley, getting ready to hit a blind shot. Their partner, Mr Market, is vaguely saying “Hit the ball that way".

What club should they use? Can they find the sweet spot, and if they do, where will the ball end up?

The Fed is like the golfer, even a gifted athlete, who has had a great deal of instruction and not much actual playing time. “But John,” some will suggest, “the Fed has been doing this for years.” I would suggest that not with this set of circumstances. What worked in 1990 or 2001 might not be appropriate today. But how would we know? They have had no real experience with this course. They may know what their clubs will do with a given set of circumstances, but they are hitting blind.

There are three possible scenarios, corresponding to tightening too much, too little, and thirdly, the sweet spot.

The Fed funds rate is now at 3%. It is almost certain that the Fed will raise another 25 basis points at its June meeting. The market in the form of Fed futures suggests the Fed will raise another 50 basis points after that to 3.75%.

Inflation control - US Federal reserve – figures

At the time of this writing [June 3rd] the 10-year bond settled at 3.98% after briefly touching 3.82%, because Friday’s unemployment data disappointed the markets. Quite the wild ride for the boys in the pits! Bill Gross at Pimco, the world’s largest bon fund, suggests that the 10-year is going to 3%, and Rosenberg of Merrill Lunch suggests we could see 3.5%. If they are right, we would have an inverted yield curve - signalling recession - if the Fed raised short term rates to 3.75%. Another 75 basis points clearly seems like too much to raise rates, doesn't it?

Maybe not. Richard Berner of Morgan Stanley, among many others, argues that inflation is not yet tamed and lays out the data to demonstrate that increased inflationary pressures are clearly evident. Unit labour costs in the US are rising rapidly and productivity is slowing, which is something new. Such a trend suggests more inflation in the pipeline. The bond market will surely come around in time to understand this, he posits.

If you hold that view, it would explain why Greenspan might think the bond market is a “conundrum” as he keeps saying. If inflation is increasing, then long rates should be rising. Right now, there are only 70 basis points between the two-year and the 30-year bond: 3.57% and 4.28% respectively. With the 10-year at 3.98%, the difference is only 41 basis points. That is a very flat curve.

Historically, the Fed has tended to tighten for far longer and to a greater degree than most observers originally felt they would. They have been nothing if not consistent in their fight against inflation. This is certainly Greenspan's last year. Is it not reasonable to ask why he would back off in his fight against inflation at the end of his career?

And then there are those who argue that the US economy is already weakening, and that the Fed should pause in its interest rate hikes.

Last month's ISM is a perfect illustration. The ISM is a monthly barometer of the activity as noted by the purchasing managers of US manufacturing companies. If the number is above 50, manufacturing is growing. The number for May was 51.4, but the trend is disturbing. Last year at this time, the number was comfortably above 60. Each month since then, we have seen the number drop slightly. Last month is dropped 1.9. Another such drop would put it below 50. The trend suggests that will happen this summer.

Paul McCulley points out the Fed has never tightened when the ISM drops below 50. We could be nearing that point.

Newly-appointed Dallas Fed Governor Richard Fisher suggested that we are close to the end of the tightening cycle. "We've gone through eight innings here, 25 basis points an inning," Fisher told the Wall Street Journal, referring to the eight quarter-percentage point rate hikes made by the Fed since it began hiking borrowing costs this time last year. "The next meeting in June is the ninth inning,” he said, continuing his baseball comparison. “We'll take a look after that. We may have to go into extra innings in this contest against inflation."

Fisher’s comment was one of the reasons that interest rates on the long US bond began to drop. I'm not certain how much weight we should give to a newly appointed Fed Governor; especially given the other Fed governors are suggesting that the "measured approach" is still the watchword for the day.

But be that as it may, he may be right. Friday’s US employment numbers disappointed with only 78,000 new jobs. But it may be worse than that. Buried in the report is something called the Birth/Death ratio. This is an effort by the US Bureau of Labor Statistics to guesstimate how many jobs were created by the private sector in the last month. This month, the number was 205,000. But if the economy is slowing down as the ISM number and other economic factors seem to suggest, then 205,000 may be too high. Further, the B/D ratio for the last half of the year is typically much, much smaller. In July, the number will likely be negative.

Inflation control - US Federal reserve - disappointment

All of this suggests that when the Fed meets in August, the economic data could be quite disappointing. A slowing economy, a poor manufacturing environment and a weak jobs number might cause them to pause, especially if inflation pressures seem to be backing off.

What are the risks of the above scenarios? If rates are raised too much, it could choke off growth in the economy. Indeed as noted above, there are reasons to think that the economy is already slowing.

However, if interest rates are too low, there is a risk that the economy could become overheated and inflation pick back up. If inflation did rear its ugly head, it would in fact cause long rates to rise. If US mortgage rates were to rise, as noted above, it would have a serious impact upon the domestic economy - and by extension, the global economy, too.

This next little tidbit actually surprised me. "The economic consulting firm Economy.com estimates that total cash raised from [US] mortgage equity withdrawals exceeded $700 billion last year (8% of disposable incomes) up from $250 billion five years earlier." My back of the napkin analysis suggests this was almost 6% of the total US GDP. If you slow the rise in the value of the homes down too much or, God forbid, you actually see a fall in home prices, it would suggest that mortgage equity withdrawals would be greatly reduced. That would clearly have a negative impact on economic growth, as consumer spending as financed by mortgage equity withdrawals would slow down. We’re already seeing this in the UK.

But if the housing market continues to rise at recent rates it becomes clear at some point that we have another asset bubble. This is a bubble that if it were to burst would have far more widespread consequences than the bursting of the stock market bubble.

Thus the risks: too much tightening and the US risks recession. Too little and we risk inflation. Either are bad for the US housing market and - ultimately - the world economy.