Straight Down the Middle

by John Mauldin

Of course there is a scenario that the Fed is trying to pursue: they want to hit it straight down the middle. They would like to see rates rise enough to slow the rise in home prices, but not enough to choke off the market. They would like to see rates stay low enough to help stimulate the economy if we are indeed getting ready to go through what looks like a “soft patch.”

If they can find the sweet spot, the current economic expansion, along with a rising trade deficit could last for several years longer. It won’t make the problems go away, and indeed, the ultimate resolution may even be worse, but in the short term life would go on.

Of course, the trick is to figure out what the right rate is. Where is the sweet spot? Is it 3% or 3.5% or 4%? Should they pause after the June meeting and then wait to see what happens to inflation and the economy before another rate hike? Will they preemptively continue to raise rates wanting to drive a stake in the heart of inflation?

Greenspan told us two summers ago that the Fed has to take into consideration the possible negative impacts of their decisions and weigh them more than the potential positive impacts. “First, do no harm.”

The world is still a disinflationary world, and a recession in the next year would bring about a renewal of deflationary fears. If we were to enter a recession, with inflation relatively low, very little potential for stimulus from lowering rates and no potential stimulus from more tax cuts, it would be worrisome indeed. The Fed would not have the deflation fighting tools it had in 2001-2002. To use another golf analogy, it would be like playing with only 7 clubs rather than the normal 14. While Tiger Woods could probably play almost as well without a driver and a putter, it would be a serious handicap for the rest of us.

The clear front-runner for the new Federal Reserve Chairman is Ben Bernanke. He has made it quite clear that the Fed would be willing to use “unconventional means” (remember the printing press?) to fight any potential deflation. This is not a scenario that anyone wants to actually have happen.

I think the Fed will come to see that the preponderance of risk is that raising rates chokes off the economic expansion. If inflation does become a problem at some later date they can always raise rates at that time. In fact, dealing with some future recession when inflation is higher than it is today would actually make it easier to deal with any potential deflation.

So, you raise rates at the June meeting, and then see what the data from July tells you at the August meeting. You change the language at the June meeting to let everyone know that any future interest rate hikes are now determined on a meeting by meeting basis. To use Fisher’s baseball analogy, you call a rain delay after the June meeting.

Will it work? No one knows. No one knows what the natural level of interest rates should be. No one knows how all the myriad influences on the economy will play out. And it is not altogether clear that even if the Fed hits the ball on the sweet spot that it will land at a safe place. When you’re hitting blind, all you can do is drive over the hill and hope for the best.

This is why I would argue that we should more clearly define the role of the Federal Reserve. If the Fed focused on steady growth of the money supply in line with GDP, and then let the markets deal with the business cycle, we would have less of this uncertainty. If the US government were to have some fiscal discipline we would see our negative trade balance and other problems begin to dissipate over time. But since that scenario is the least likely of any I have painted, let’s focus on what might likely happen.

I would give the first two scenarios a probability of 40% each, and the middle scenario a probability of 20%. Finding the middle of the fairway when you’re hitting blind is a very difficult task. We are getting closer to the end game, and I think the market realizes it. Each set of data is going to be seen as more and more important. That is a scenario for more volatility like we saw today.