To Pause, or Not to Pause?

There has been much debate over whether or not the Fed should pause their rate hike when they meet next week, so the full effects of Katrina can be absorbed. John Mauldin examines what decision would be in the best interest of the economy…

I’ve recently made the case that the Fed needs to pause in its "measured tightening" cycle, for at least the September Fed meeting, until we can see the full effects of Katrina and the oil shock upon the U.S. economy. We will really not know all that much by September 20th, and given the Fed emphasis upon approaching central bank policy as a task of risk management, that seems the prudent thing to do.

Pausing for 40 days, until the November meeting, though, would not suddenly send the economy into a dangerous spasm of inflation. If the economy adjusts, and oil refineries and shipping come back online in good order by then, as it most likely will, then they can continue their tightening cycle with no danger to the economy. But if we do find problems, the downside risk seems, to me, to be too great.

It is not yet altogether clear that Mississippi’s shipping will be back up in time for the fall harvest. Any other shocks (we are still in the middle of hurricane season) at this delicate time could be of real concern. Patience, at least for 40 days and 40 nights, is called for. Even God took that long to get things back to normal when things needed cleaning up.

Post Katrina, we have had three Fed governors speak. Frankly, they still seemed to be tied to the party line of the potential for a return of inflation. I found no quicker or more on-target assessment than that which comes from Dennis:

Measured Tightening: Is the Previous Course the Proper Course?

"We think, therefore, the odds are greater that the Fed shall pause and do nothing at the upcoming meeting. We think that is what reasonable people would do under the circumstance. We think that is the right thing to do. But are we certain that is what the Fed will do? On that we are wholly uncertain.

"…Having stated our preference, we must admit that the ‘hawks’ have been rather overtly public in putting forth their position that Katrina is exogenous and that their previous course of action remains the proper course. We noted, of course, the very hawkish Gartman [by "hawkish" Dennis means aggressive in controlling inflation, and in this instance by raising rates] comments made earlier this week by Mr. Moskow of the Fed Chicago. Now we note the comment made recently by Mr. Santomero, the President of the ‘Philly’ Fed, who said, ‘As the expansion matures, the price dynamics at work in the economy will shift [upward].’ Mr. Santomero was concerned about inflationary forces at work.

"We understand that concern, and there is no question but that Katrina will exacerbate those concerns as the re-building process begins over the course of the next several months and shall continue for several years into the future. But, does that mean that the Fed cannot choose to pause, if only for a while? We think not, but Mr. Santomero may think otherwise… and let us be rather honest: his opinion counts a bit more than does ours.

"What really caught us off guard, however, were the comments from Ms. Yellen, now the President of the Federal Reserve Bank of San Francisco, and a former Board member of the Federal Reserve. Ms. Yellen, we would hope, is fully cognizant of the Fed’s ‘political’ situation and so we suspect that her comments are weighed, and weighed again before they are made. Thus, we tend to listen to Ms. Yellen quite closely, and she has spoken rather overtly ‘hawkishly’ in the past day or two. Noting that the effect of Katrina will indeed slow GDP growth in the fourth quarter of this year, Ms. Yellen nonetheless said that the effect of rising oil prices may more easily be passed through to the consumer than they have been passed in recent years. Her tone was one of very real concern, rather than of merely being modestly bothered by that possibility.

"So now we have Moskow, Santomero and Yellen staking out the ‘Hawk’s’ position and doing so rather publicly. We are hoping to hear from the ‘Doves.’ We await someone to take up that position and to do so as publicly as Moskow, Santomero, Yellen & Co. have staked out theirs. The problem is that in the company of central bankers, the ‘dove’ is always the outcast bird."

Measured Tightening: Should the Fed Act Pre-emptively?

It is easy to see inflation as a potential problem. The serious rise in housing prices, and Fed concern about them, is well documented. The Fed is getting ready to pump massive amounts of money into the economy. Coffee is up seven percent and sugar up 30 percent due to delivery and shipping problems. The materials needed to rebuild, like copper, aluminum, and timber will be in large demand. As oil rises, shipping prices for products are going to rise. If Yellen is right, and price increases imposed by increased costs "stick," one can readily argue that we could see a surge in inflation. And with inflation near the top level of what the Fed is comfortable with, shouldn’t the Fed act preemptively to make sure inflation does not come back?

The short answer is no. There are forces, which combined with Katrina, could change those trends. Let’s look at some of them.

Let’s turn to those smart guys at Cumberland Advisors for an analysis of how much pressure the consumer is under. They think the Fed might come to a full stop, as they are concerned the economy will roll into a recession if the Fed continues on its current path. I have noted in past letters that increased energy prices are going to take a toll on consumer spending, but it is not just energy. Increased interest rate costs on mortgages, the new Alternative Minimum Tax and Katrina all make this worse; they put a pencil to the problem to give us an estimate of the cost and the potential hit to consumer spending.

"Energy is the largest of a four-pronged attack upon the economy. We will compare the size of these four prongs with Disposable Personal Income (DPI) to demonstrate the magnitude of the problem and why they may lead to a consumer-led slowdown.

"Quickly, DPI is about nine trillion dollars according to the latest Bureau of Economic Analysis (BEA) estimate. It is what the 295 million of us have left to spend after taxes and some other minor adjustments. It is the source of our consumption spending and our debt payments. Fortunately, BEA data break out the energy costs we incur."

Measured Tightening: A Look at Housing Prices

Let’s hold that thought while we look at housing prices. This point comes from Martin Barnes at Bank Credit Analyst:

"The current 11% year-on-year gain in real house prices compares to a 50 year average of only two percent. The current growth is three standard deviations above its mean, and historically, this has broadly been a mean reverting series. The odds are high that the growth in real house prices will fall below zero in the next few years.

"The low level of long-term interest rates will provide a cushion for housing, but will not be able to prevent the market from cooling. The main drag on housing may come from the reduced supply of mortgages rather than a more typical interest-rate induced drop in demand. However, regulators are likely to clamp down on the more speculative types of loans and this will constrain housing demand. Moreover, as we have noted in the past, the experience of the U.K. and Australia suggests that even a leveling off in prices will be sufficient to cause a marked retrenchment in consumer spending growth."

Recent data suggests that the housing prices may be under some pressure. There is a very close correlation between housing prices, consumer confidence, and consumer spending. Any decrease in consumer spending will be in addition to the decrease noted above by Cumberland. All of this suggests that it is time to be cautious. Even if the Fed were to raise rates, they are close to the end of the cycle. Rates are close to where they should be even if you are very hawkish on inflation. There is no need to hurry the process, and every reason to wait. In the past, the Fed has tended to go too long and too far in their rate hike cycle. No need to repeat that mistake.

In a call with Martin Barnes today, he made it clear that he believes the Fed will pause. Martin is as astute an observer of the Fed as any person I know. When asked about the recent Fed speeches, he says simply that they are continuing with old Fed policy and that things will change when Greenspan decides they will at the next meeting. It is Greenspan’s decision that counts. Finally, Martin was forecasting a slowdown prior to Katrina, but he does not think we will fall into recession. He sees it as more like a mid-cycle slowdown similar to what we saw in the mid 1990’s.

There are more and more calls for the Fed to pause in September. Clearly the markets are expecting them to do so, and this has given a boost to the stock market. There is the perfect excuse and a very easy-to-write reason: They could simply say they wait for more clarity, but barring some new data suggesting a softening of the economy, they will continue on their rate-hike path.

Yet, there is less, rather than more clarity as to what they will do. This meeting, barring a comment by Greenspan, is shaping up to be the most interesting in a long time; as everyone has known for the last ten rate hikes, that it would be at a measured pace of 25 basis points per meeting. At least for this meeting, there is uncertainty.


John Mauldin
for The Daily Reckoning

September 15, 2005

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

In his easy-to-read, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. Bull’s Eye Investing is a must-read road map if you want to avoid the pitfalls of the modern investing landscape…

More of the world according to The Daily Reckoning…

The trouble with trouble is that Americans can’t afford it. They have spent all their money on granite countertops. When a rainy day comes, they have nothing saved up for it. The flood on the Mississippi delta, for example, was quickly followed by an emergency-spending package of more than $50 billion.

Whether the spending will help anyone or not, we don’t know. But the loot has to end up in someone’s pockets. We don’t know where the money will end up either; but we know where it won’t come from. It won’t come from American savings because they barely exist.

In today’s paper we find that another delta has gone under: Delta Airlines. The poor fliers carry $18 billion in debt. As oil prices rose, they had no reserves, no cushion, no savings in which to turn. Yesterday, the burden became too great; they went to court to ask the government to help get creditors off their backs.

What a way to run an airline!

But we cannot single out Delta for mockery. Three out of seven of America’s top airlines are now bankrupt. A fourth, Northwest, is said to be considering it.

It makes us wonder. Rising fuel costs have been widely predicted, including here at The Daily Reckoning. We can understand that airline executives wish to cut costs, but The Daily Reckoning is free. What’s more, higher energy prices were not only an obvious risk, but practically inevitable. Every single day, beginning with the first barrel of oil ever pumped in Titusville, Pennsylvania, the world’s ultimate quantity of oil has gone down. Oil engineers also noticed that even though extraction technologies grew more sophisticated, they were not able to keep up with the pace of global consumption. By the 1970s, America’s oil output was already in decline. Production for the entire world should go into decline this year or the next.

It is true, too, that alternative energy sources are being discovered and exploited. But there were no plans that we know of to retrofit Delta’s fleet of jumbo jets to run on batteries or solar panels. They were designed to run on petroleum products – a lot of petroleum products. Our friend Byron King has estimated that a single regularly scheduled transatlantic passenger plane consumes more energy than was used up in the first 100 years of in the exploration and settlement of North and South America. (We can’t recall his calculation, but it is something like that.) Which means that the airline industry must be particularly and obsessively sensitive to fuel prices.

Oil prices have gone up; but in real terms, oil is still not as expensive as it was during the oil shock of the 1970s. Since then, the planet used up more oil than it had in any three prior decades in history. Anyone could look back and see the heights to which oil could go. And anyone could guess about the effect of the last 30 years of usage: The real price of crude might well be higher than it was in the ’70s, not lower.

Which makes us wonder: What did airline industry executives talk about when they got together? The weather? Golf? Kant’s concept of the categorical imperative? How could they run a business so acutely sensitive to energy without making any provisions for higher prices? Did it never come up in conversation?

Delta executive number one: "Uh…what are we going to do if oil prices rise?"

Delta executive number two: "Don’t worry about it. All airlines will be in the same fix. We’ll all just have to raise our prices. And renegotiate our union contracts. "

Delta executive number three: "Are you kidding? As competitive as this business is? We’ll all go out and borrow money so we can use the crisis to gain market share. If we raise prices we’ll lose market share."

Delta executive number four: "But what good will it do to get more market share if we have to operate at a loss? Won’t we be losing money on each sale and trying to make it up on volume?"

Delta executive number five: "Oh, stop worrying. We’re the most dynamic industry in the world’s most dynamic and flexible economy. We’ll think of something."

More from our friends at The Rude Awakening:


Chris Mayer, reporting from Gaithersburg, Maryland:

"It’s frightening…It’s difficult…It’s harrowing…and it’s very, very profitable. I’m talking about ‘distressed investing,’ also known as ‘vulture investing.’ It is the ultimate expression of contrarian investing…"

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening:


Bill Bonner, back in London:

*** Delta Airlines was founded in 1924. It operated through several wars, a stock market crash, the Great Depression, countless industry bankruptcies, inflation, deflation, recession, boom, and bubble. And yet, there it sat, like the other delta at the mouth of the Mississippi, blankly waiting for a storm that anyone could see coming just by looking out the window. When trouble came, neither delta could afford it.

But that is the way the world works, dear reader. People do not make logical, rational and sensible choices. They get caught up in things that have a logic of their own. All over America there are millions and millions of Delta households, Delta businesses, and Delta governments – state, local and federal. All add debt and increase expenses – knowing full well that interest rates could rise, incomes could fall, house prices could drop, and lenders could balk at extending further credit. Any or all of those things are as obvious, imminent and inevitable as an increase in oil prices. When they come, Deltas will go underwater.

*** "If America becomes so unglued when bad things happen in its own backyard," Thomas L. Friedman quotes a hack colleague from Singapore, "how can it fulfill its role as leader of the world?"

Of course, the Romans had plenty of trouble in the homeland, too. Fires burned down much of Rome itself. There were periodic insurrections, slave rebellions, fights for imperial succession, murders, incompetence, unbelievable depravity, corruption, vice, and civil wars. The city of Pompei was completely destroyed by the eruption of Mt. Vesuvius. But that didn’t stop the Romans. They carried on their campaigns of military subjugation for hundreds of years, despite troubles at home.

Don’t worry, dear reader, the New Orleans inundation will not prevent America from playing its role or fulfilling its historical mission. The show must go on!

*** Edward’s Frenglish is getting worse. In Paris, he spoke French at school and English at home. Now that he is with other bilingual children, he seems to mix the two languages more and more.

A sample sentence: "My teacher told me that if I didn’t do tout mon devoir en classe, I would have to do more travail a la maison."

We are beginning to wonder about bilingual education. Instead of making him competent in both languages, so far it seems to be making him incapable of speaking either one correctly.