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Tuesday, December 13, 2005

When will the Fed stop??

Today's news was that the Fed raised interest rates another quarter point to 4.25%. The real meat behind the story, according to the press, was the speculation of when they will stop raising rates. Little covered was the potential for inflation and slowing economic growth.

In my opinion, the biggest danger in front of us is a return to stagflation. It is amazing that it only takes several decades for us to believe a reoccuring phenomena is actually something new.

According to the Fed's statement, "further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance." This statement implies that sustainable economic growth and price stability are in contrast to one another. The risks need to be kept in balance.

On the contrary, I believe the Fed has already put us in jeopardy, by being too eager to lower rates and stimulate the economy throughout Greenspan's tenure. This activism has led to what is called the "Greenspan Put", which is the market's belief that Greenspan will come to the rescue with liquidity in the event of an economic and/or market downturn. The realization of the Greenspan Put's existence has created a moral hazard, as market participants have taken more and more risk, and generated more and more credit growth.

This degree of credit growth sustained economic growth throughout the 1990s and for the last five years, but at the expense of the future. Now, with our economy burdened with debt, the Fed will have to either (i) allow for a deep recession, which will cause enough defaults to bring debt levels back to sustainable levels; or (ii) continue to increase liquidity, to generate enough inflation, so that the real levels of debt diminish.

It is my belief that the Fed will choose the path of least political resistance, the latter path, and continue to increase liquidity.

Little commented on by today's journalists was the idea that in taking this path the Fed might have to continue to let inflation rise, possibily eventually leading to stagflation.

Certainly, my viewpoint is not the current market consensus. However, as a taste for posts to come, I will leave you with two thoughts.

One is that during the Clinton era, the CPI index was adjusted to incorporate new techniques, such as hedonics. These techniques were not used in the 1970s and 1980s. Today's measure of inflation is already evelated - at 4.7%. However, if we were to measure it in the same way as we did 20 years ago, it would be whopping 7.0%!

Another point is that I have long thought that as the U.S. raises interest rates, other countries will keep their rates low or even lower rates. THIS HAS TO HAPPEN. Right now, the U.S. Current Account Deficit is well over 6% of GDP, meaning we are consuming $2 billion more a day than we are producing. To bring this deficit into balance, other countries will have to consume more, and we in turn will have to produce more. Another way of saying this is that we will have to raise interest rates to lower consumption, while they will have to lower them. As evidence of this trend, during the latest Fed raising cycle, the U.S. has raised its interest rates 3.25%, Europe has raised its rates 0.25%, Japan has not raised its rates, and this week Mexico lowered its rates! Again, this points to the idea that the U.S. could experience inflation (due to increased global consumption), even as our economy slows (due to decreased domestic consumption). The end result is that domestic-based prices, such as labor and housing, will fall, while internationally-traded commodities will rise in price.

That's why - even at over $60 a barrel - I'm bullish on Oil!

If the mass media writes in awe when Oil crosses $70, you should smile and thank your XOM LEAP Calls!


  • Energy back up, NG new high. "experts" talking $20mcf on NG. The trend for higher inflation in place. Waiting fo rhte shoe to drop in the yield market but it refuses. Seems like a decent time to have your hands in you pockets.

    By Anonymous Flipper2058, at 11:13 PM  

  • Sounds as if gold is a good bet for the future since as oil, it is a internationally traded commodity. One reason inflation has been low over the last 10 years is that competition with imported goods and off-shoring labor has kept prices low. The Fed does not have total control over prices. It's policies can help cool down inflation or heat it up.

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