June 4, 2008
- The Fed has dropped interest rates far and fast and that is a very important and effective stimulus for the economy. However, fortunately or unfortunately, the Fed has a dual mandate. They must not only contend with economic growth, they must also – at times – battle inflation.
- Fed Chairman Ben Bernanke recently gave his first speech in two months on the economic outlook and offered some clear signals that the Fed is growing more concerned about inflation expectations. Considering the Fed’s expectation of a return to U.S. economic growth in the second half of 2008 there is a concern that the Fed could soon begin a campaign of raising interest rates, thus blunting any economic recovery.
- There are definitive data points arguing for the expected second half recovery, but the housing and the credit markets are still too delicate to handle even a nudge in the wrong direction. While raising interest rates may actually be the right move by the Fed, given their dual mandate, it nonetheless may too be too significant a negative shock for the U.S. economy.
As the adage goes, “don’t fight the Fed”. That mantra has been drilled into investor’s heads to the point where, perhaps, it has become meaningless. This saying, an investment policy for some, argues that as interest rates are declining or as they are held low, then investors should be buying stocks.
But the title of this article, “The Economy vs. The Fed” refers not to declining rates or to the promise of rates held low, but rather to the prospects of the Fed raising rates. The Fed, as we all know, has the dual mandate of economic growth as well as keeping inflation tamed. The Fed had been lowering interest rates aggressively citing that they were more concerned with pumping up the economy than they were with fighting inflation.
On Tuesday, June 3, Federal Reserve Chairman Ben Bernanke gave his first speech on the economic outlook in two months. In this speech he clearly signaled that the end of monetary easing had come, saying that “for now, policy seems well positioned to promote moderate growth and price stability over time.” With that, the Fed is likely to make no changes during their next meeting on June 24-25. And that would be good for the economy – at least it would be if rates were held low for the next year or so.
However, Bernanke made several other comments that suggested raising rates as early as their August 5th meeting. His speech made reference to not only the expected growth in the second half of the year (no additional need to lower rates) but also to the need of fighting inflation and inflation expectations (which means raising rates). Historically, after a Fed easing cycle the resumption of tightening begins anywhere from 6-24 months after the last cut date. Thus August would be early, but not dramatically out of line with a time one might reasonably expect. The problem is that while we are certainly beginning to see data points supporting a recovering economy, it is still early in the cycle and there are still delicate problems (housing and credit markets come to mind) that should not yet be nudged in the wrong direction.
The fed funds futures contracts are, so far, still pricing in just a low probability of a rate hike, but the sentiment (especially after yesterday’s meeting) seems to be moving in that direction. The bond market is increasingly betting on a near-term hike in interest rates as we see the 2-to-10 year Treasury spread (the amount of yield difference between the two) continue to shrink markedly over the last few months.
The bond market seems to be joining us in our fear that inflation hawks will soon dominate the Fed. The Fed may wish to target inflation, and that is their mandate, but higher rates will exacerbate still existing and significant problems in both the housing and the credit markets. Also, higher interest rates will move to variable rate debts (credit cards, mortgages, loans, etc) and drain additional cash from consumers and from corporations. It is not that the Fed will be doing the wrong thing – as we said, it is their job to fight inflation. But in doing so by raising interest rates, those higher rates will draw great concern from us as to the durability and sustainability of the economic growth we (and the Fed) are expecting in the second half of 2008 and into 2009.
But before the Fed dampens the playing field, let’ take a look at the current score. According to prices of futures traded by the Intrade market, the chances of a recession are now about 30 percent. The implied recession was as high as 73 percent in early January after a series of poor economic data, and then all the way up to 78.5 percent in March during the Bear Stearns crisis. What data has the market and the economists took solace in to suggest that the recession that everyone predicted may never come?
This week the Institute of Supply Management (ISM) manufacturing survey edged up from 48.6 to 49.6; anything below 50 indicates contraction. The 49.6 shows a slight improvement month-over-month. And while slightly contracting, the ISM number falls much more significantly during “real” recessions. In 2001 the ISM hit 41 and in 1990 the ISM hit 39.2.
Also this week, global semiconductor-chip sales were reported to have risen 5.9% in April from a year earlier. The number was pretty much flat with March, but not only is that not a contraction but that is a normal seasonal pattern.
The data is getting more supportive of the second-half recovery we predicted in January. However, an August interest rate hike by the Fed – whether the right thing to do or not in order to best balance their dual mandate – could be the start of a tightening cycle that would push us closer toward a “real” recession and not just the type of mid-cycle that the vocal majority jawboned us into.