Searching for the Sweet Spot
The top questions today revolve around Fed policy, the trade deficit and the dollar. John Mauldin lays out three scenarios involving possible future Fed policy actions – and what they may mean for the U.S. and global economy…
The Fed 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 rates at a measured pace, they should continue to do so for the rest of the year (for a variety of reasons). Raising 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 interest rates should be, and 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 Fed? The Fed is 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?
They are 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.
Fed Tightening Cycle: Three Scenarios
There are three possible scenarios, corresponding to tightening too much, too little and 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%.
At the time of this writing, [June 3, 2005] the 10-year bond settled at 3.98% after briefly touching 3.82%, because the unemployment data disappointed the markets. (Quite the wild ride for the boys in the pits.) As noted last week, Bill Gross 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 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 labor costs 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. 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 what 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 unreasonable to ask why he would back off in his fight against inflation at the end of his career?
Fed Tightening Cycle: Stop the Rate Hikes
And then there are those who argue that the 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 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 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. We’ll take a look after that. We may have to go into extra innings in this contest against inflation."
His comment was one of the reasons that interest rates on the long 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.
Be that as it may, he may be right. [Friday’s] 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 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.
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.
But what about those who argue that inflation is getting ready to come back? There are even more who argue that inflation is under control and is likely to begin heading down.
What are the risks of the above scenarios? If rates are raised too much, it could choke off the 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 mortgage rates were to rise, as noted above, it would have a serious impact upon the U.S. economy.
This next little tidbit actually surprised me. "The economic consulting firm Economy.com estimates that total cash raised from the 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 U.S. 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.
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 we risk recession. Too little and we risk inflation. Either are bad for the housing market and the economy.
for The Daily Reckoning
June 07, 2005
So, what’s the final scenario that the Fed could choose?
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…
Do you see a bubble, dear reader?
Housing prices in certain areas of the country are definitely in bubble-mode. They are rising at an unreasonable and unsustainable rate.
People don’t ask questions when prices are rising. But if they did they’d want to know why a house is worth twice as much in 2005 as it was 10 years ago…how it is possible for house prices to grow faster than GDP, inflation and incomes…and what happened around the turn of the century that caused house prices shoot up faster than they have done in the last 50 years?
We grew up near one of the biggest growth industries of the 20th century – the U.S. federal government. In the 50s, Washington, DC was far away. But it was growing fast. By the 1970s, the Washington suburbs had spread out through Prince Georges County all the way to the Chesapeake Bay. And by the 1990s, it seemed like everyone in the area was connected to the federal government in some way.
We didn’t know it at the time, but Washington was becoming the political center of a huge empire – the world’s only real hegemon of the late 20th century and early 21st. Naturally, property prices rose – as the area attracted hustlers, hangers-on, and hacks not only from all over the nation, but from all over the world. Every minor country and major industry wanted a presence in the imperial capital.
Property prices grew along with the empire. But never spectacularly. When a city stretches out around its center, its buildable surface area expands by the square of the distance from downtown. The outer circles of growth are many times bigger than inner ones. So the supply of housing easily keeps up with demand – unless it runs into a physical barrier, such as the Hudson and East rivers around Manhattan and the mountains hemming in Aspen, Colorado.
But even though builders are putting up thousands of new houses all around the Capital Beltway, prices are now running up as much as 10 times faster than real GDP growth. This phenomenal inflation of house prices only began after 2001. Part of it could be caused by George W. Bush’s big boost of spending. After years of relative decline during the Clinton administrations, for example, military spending is soaring. So is domestic spending. This spending puts more money into the local economy.
But a larger cause almost certainly comes from the Fed’s "emergency" level interest rates. The original emergency was trying to get the U.S. economy out of its 2001 slump. The recession ended with the New Years’ parties of 2002. Mr. Greenspan has since raised rates – but they are still at or below real rates of inflation. Which is to say, the Fed is still giving away money.
A bank may take the money directly. But an individual cannot borrow directly from the Fed. Still, he can take advantage of the Fed’s apparent generosity by refinancing his present house or buying another one. This is the gas that is causing the nation’s property bubble.
If they were in the mood to ask questions, people might also wonder what the emergency is now? Why doesn’t the Fed "normalize" rates?
The maestro edged towards this question recently in unemotional terms. He referred to a "conundrum." Specifically, he wondered why long bond yields were falling, even as he pushed up short ones. He did not mention it, but he might also wonder why employment numbers are still disappointingly low.
Our guess is that the Fed chief sees a new emergency – trying to undo the damage from his last emergency operation. Cutting rates so low for so long Mr. Greenspan turned a slump into a residential property bubble. If he were to "normalize" rates, the bubble would pop. Then comes the real emergency.
More news, from our team at The Rude Awakening:
Eric Fry, reporting from Manhattan…
"Pope Gregory the Great categorized humanity’s most critical foibles as the ‘Seven Deadly Sins.’ In the twenty-first century A.D., this editor encourages investors to avoid at least one of these deadly sins: Pride."
Bill Bonner, with more views:
*** This past Sunday’s edition of The New York Times featured an article, "Believing (and Believing and Believing) in Bullion." The writer, Stephen Metcalf, describes his trip to the Federal Reserve Bank of New York’s vault that holds the world’s largest stash of gold – totaling almost $100 billion.
Metcalf was given a tour by a Fed spokesperson, and he tells of an interesting exchange that went on in the vault when Metcalf remarked that gold represented an "anachronism."
The spokesman agreed emphatically – until Metcalf commented, "And yet, all these nations, they hold on to this anachronism, just in case…"
"At this," Metcalf writes, "a light chill entered [the Fed spokesman’s] voice.
"’I don’t think anyone in a policy-making position,’ he explained to me politely, ‘seriously believes that everything else of value could disappear, leaving only gold.’"
Maybe the "policy-makers" over at the Fed don’t believe that gold is ultimate monetary insurance…but we’ll still hold it – just in case. Like we wrote yesterday, we don’t want to get caught in a downpour without our umbrellas.
*** It’s the "end of free spending" here in Britain, says today’s International Herald Tribune.
Retailers are feeling the pinch. Shoppers in England are pulling back after years of expanding credit. What’s behind the slump in consumption spending is a slump in the house market. Britain’s housing boom began years before America’s. And, at least in London and the southeast of the country, prices are even higher than they are in most of the United States. But when residential housing began to peak out last summer, it seemed to cause a slow-down in the entire economy.
A commission appointed by the Conservative party, headed by Lord Griffiths of Fforestfach, a former advisor to Margaret Thatcher, looked at the economy this year. It concluded that personal debt had become a "time bomb," after a huge run-up in consumer spending since the late ’90s. Consumer debt in Britain now totals nearly $2 trillion, which is a lot of money for a small island. Now, mortgage applications are down. Retail sales are down. And economists are wondering what to do about it.
As in America, manufacturing has declined steadily in Britain. Compared to Germany or America, British manufacturing has been in decline since the end of the 19th century. And in the last three decades, manufacturing has been falling in all three countries. This has left economies dependent on consumption. When consumers stop buying things, the clerks lose their jobs. With no strong manufacturing industry – often selling to foreigners – there is no offsetting strength in the economy, and no obvious way to increase consumer spending – except by luring consumers deeper into debt. This is the essential problem faced by all major Western economies – but especially by the Anglo Saxon economies, which have emphasized consumerism and debt more than in Europe. The economy can "grow" only by consuming more. But in order to spend, its consumers need incomes. How do they earn more money when they are no longer manufacturing? And they cannot manufacture because their labor rates are too high to compete in a globalized economy.
*** The empire needs agents, administrators, engineers, proconsuls, and tax collectors all over the world. We had the impression we were witnessing a harvest of them when we attended Jules’ graduation at the American School of Paris. Never had we heard the words "global," "international," "multi-national," and "multi-cultural" used so often or so favorably. The graduation ceremony left little doubt about what the 17- and 18-years olds were supposed to: go forth, go to college, and then take up jobs throughout the empire, using the language and cultural skills given to them at the ASP. Nor was there any doubt expressed about the empire or its aims. Every graduating senior was expected "to make the world a better place" by spreading American values, American culture, American democracy and American business over the planet, like a coat of grease on a tennis ball.
No one was encouraged to save his money. No one was urged to work hard…or study hard. No one was warned to stand up straight, say please and thank you, or remember the golden rule. No one was advised to mind his own business, get married, raise children, or learn to do something useful. Nope; it was all about the "challenges" of the big, wide world in 2005 and beyond.
Class of 2005: Good luck.
But we have some helpful advice of our own.
First, get rid of radios and televisions. You need a clear head if you’re going to face real life. Then, throw away iPods and MP3 players, or at least put them away during business hours. Forget about the challenges of the 21st century. Focus instead on your own challenges. If you want to continue living at the standard of your parents, what are you going to do that will make each hour of your labor worth 20 times more than, say, that of an Indian or Chinese? Better yet, forget about how much you earn. Focus on how to deserve what you have. And forget also about having a good time. Forget about personal happiness. Instead, focus on taking out the trash and cutting the lawn…and helping your poor father when its time to cut firewood or put up tomatoes. Pull up those pants and put a belt on. And stop chewing gum. Get to work. You graduated on Sunday. It’s already Tuesday. What, you don’t have a job yet? When I was your age I had two of them. I had to cut tobacco all day in the hot sun for $5 a day. And my brother and I only had one pair of shoes between us…so we had only one shoe each. We’d switch shoes at noon so our feet wore out evenly. So stop complaining.