Yesterday was Ben Bernanke's first shot at setting the Fed Rate. As we all know by now, it was increased once more by 25 basis points, to 4.75%. Technically, this should help invert the yield curve even more... but we shouldn't care about that. This indicator which has almost always predicted a recession in the past has recently been announced as obsolete. This time, it's different. The only reason why lenders do not need a higher interest rate to compensate for the risk of lending long term is because of the rock solid confidence in the US economy. We'll see. As always, time will tell!
In any case, what is held in store for the future? Well, one reason so many baby steps have been taken from 1.00% to 4.75% is that any sudden moves could throw the whole financial system out of balance....
You see, really, the interest rates have to go down!
US Consumers are stuck by the throat. There were 2 million bankrupcies last year, with the economy growing at a healthy 4.5% clip... we can't afford a slowdown. Raising the rates will kill the housing sector, which has provided fully 50% of all US economic growth in the past 5 years. Think of all those real estate brokers, home builders, renovators, housing lawyers, mortgage bankers that will end up on the unemployment line...
People take out 7% of GDP out of their house "equity" each year to finance granite countertops, a new SUV, or just to pay for ongoing expenses... the US consumer is at the end of the line and needs a break!
So why are interest rates going up then? Wouldn't it be so easy to just cut the rates and help out everyone? Well, it's not that simple.
The US needs to borrow hundreds of billions of dollars each year to finance its massive government deficit (780 billion a year?) or its purchases of foreign goods, the good old trade balance. Who pays for all this stuff? Chinese, Indian, Japanese, Russians, etc. And since the US balance sheet is looking so bad, the risk premium can only go up. Plus, with the printing each year of so many more IOU's, there's just more than people want!
The US dollar has gone down by 24% in the last 5 years... with interest rates going up almost 4 percentage points. If the Fed stops the hikes, it will collapse, plain and simple.
Of course, as Bernanke once pointed out... they have this magnificient invention called the printing press. The US government can just print up 9 trillion dollars to pay up its debt and forget about it (yes, it's that big... Congress just had to increase the government's debt limit last week to keep functioning from 8.2 to 9 trillion...). But then, that solution has been tried by many governments before. Remember all those countries with hyper inflation running in the hundreds or thousands or percent? When there's that many dollars floating around, each of them is worth much, much less.
To conclude, there are many guesses out there, so I will throw mine in, for all its worth. We should end the year with a Fed rate of 5.5%, and the US dollar dropping slightly more...for my own point of comparison (and for the Canadian readers) probably to 1.12$ CA.
Somewhat interesting perspective you have. I had a strong feeling that the interest rates would go up again. By at least one measure, financial conditions remain stimulative despite 14 quarter-percentage point increases in benchmark interest rates since June 2003.
A popular rule of thumb used by economists to measure the degree of monetary accommodation compares the federal funds rate with change in the "nominal" Gross Domestic Product. (Nominal GDP is not adjusted for inflation.) When the fed funds rate is below the nominal growth rate, money is considered to be "easy." The current fed funds rate of 4.5% is well below the 6.4% nominal change in GDP.
By another statistical measure, however, it may be almost time for the Fed to ease up.
At present, the fed funds rate is about 2.3 percentage points above core inflation. By almost every definition, that would put monetary policy squarely in the "neutral" category, or the level that neither stimulates nor restrains economic growth.
As Bernanke decides how high to take rates, he'll have to judge why such traditional monetary barometers are providing vastly different messages.
The key question is why core inflation remains subdued despite exceptionally easy financial conditions in recent years, a borrowing binge by consumers, high energy costs, and a tightening of the domestic labor market.
It could be that an inflationary breakout is right around the corner, just as most economic textbooks would have predicted.
In that scenario, Bernanke needs to keep raising rates, even at the risk of causing a recession. Future prosperity depends more upon the Fed retaining its inflation-fighting credibility than on extending a single economic cycle.
Or it could be that the U.S. economy has already started to slow and that continuing productivity gains and a glut of low-wage workers in Asia will keep prices contained. In that case, administering more tough monetary medicine will unnecessarily kill the economic patient.
Assuming that the economic soft landing comes off without incident, however, history suggests that U.S. stocks could be poised for a robust rally.
I remember during the 1984 Fed tightening cycle, the average U.S. stock gained only about 6%, or about the same amount as during last year's series of rate increases. After the Fed stopped raising rates, however, stock prices rose by 32% in 1985 and by another 18% in 1986.
The Fed's successful tightening process in the mid-1990s produced a similar pattern.
Stocks barely broke even in 1994 as rates rose, then shot the moon after the Fed finished its job, climbing 125% from 1995 through 1997.
Of course, there are some important differences in valuation.
When stocks took off in 1985, the S&P 500 traded at a modest 10 times earnings. In 1995, the market's price-to-earnings ratio was about 16 times. Today, the average U.S. stock is valued at 18 times trailing earnings.
Compared with bonds, however, stocks today are at least as undervalued as they were in 1984 and 1995. The story is equally compelling compared with cash yields.
Given that economic growth remains reasonably solid and inflation well-contained, my guess is that Bernanke will pass his first test in the monetary pilot's seat.
By this time next year, look for the Fed to start cutting interest rates. Though much can still go wrong - Iran, terrorism, energy prices, the dollar, the housing bubble, the bird flu - investing is ultimately about playing the odds.
The odds say stock prices will start moving much higher by next fall. In the meantime, wait patiently and buy the dips.
Posted by: ecopundint | March 29, 2006 at 08:17 PM
Great comments, ecopundit!
One potential reason I see for a disconnect between the indicators you mentionned is the manipulation of the inflation data. The CPI basket is being constantly modified now with "heuristics". For example, a 2000$ computer today is twice as powerful as a 2000$ bought a year ago, so its cost in the CPI basket is now half of last year's. For a car, prices might have doubled in the last 10 years, but now the car comes with standard airbags, ABS, etc, so it heuristic cost is about the same. Although there is some logic to it, it does manipulate the data.
Also, housing costs are a large part of anyone who own a property's budget. This is not reflected properly in the data, as it is calculated on a rental basis, ie what would you pay to rent your own house. Since the ratio of rent-to-purchase is now so high, it does not reflect the full cost of owning a house in the inflation data.
You bring some interesting historical points regarding previous Fed tightening cycles, and these should definitely be considered when trying to predict future behavior.
I also agree with your point regarding stocks/bonds valuation. Current bond valuations are amazingly discounting risk as if it was non-existant. The spread between low and high risk debt is so thinm that it encourages speculative behavior in search of yield.
In the meantime, I am sure we all hope you are right about the market taking off after the fall down-season... we keep our fingers crossed!
Posted by: Tempus | March 30, 2006 at 01:57 PM