Saturday, July 08, 2006

The End of The Fed Raising?

But first, a few quick comments on the markets. After the large ADP payroll estimate of job growth (385,000) the expectations for today's employment number was a disappointing 122,000, which sent the stock market into a funk. The bond markets rallied as we saw lower yields almost across the board, as a weaker economy will mean lower long-term rates.

But 122,000 is still not all that weak, except in comparison with the ADP numbers. Next week we will see the inflation numbers, and I expect them to still be in the plus 2% range where the Fed feels uncomfortable. Let's quickly review why I think the Fed will raise rates again in August and maybe even after that.

First, there is that obscure item called the "sacrifice ratio." How much pain in terms of a slower economy and lower employment do we take today to make sure we do not have excessive inflation in the future? Higher inflation in the future will ultimately mean even higher rates and a possible deep recession, as the Fed would then have to tighten aggressively. It is a trade-off or sacrifice. There is a number which characterizes the risks and rewards, called the sacrifice ratio, and today and for the last few years it has been high, which is why the Fed has continued to raise rates.

This is illustrated by the following sentence from a speech made this last week to the British House of Commons by Fed vice-chairman Donald Kohn.

"I think we are very well aware in the Fed that there is some risk that we would tighten policy more than necessary and that it might induce weakness in the economy... [but] there is a greater risk from not tightening." (Source: The Gartman Letter)

The headline in the paper was "Kohn Aware of Risk of Tightening Policy Too Much," but the sentence above clearly illustrates that he is prepared to do so if they think inflation is a future issue.

Second, the Fed is moving to inflation targeting. It is so far silent about this topic, but you can read the tea leaves. Bush just appointed Dr. Fred Mishkin to a recently vacated Board of Governors position. Just another academic economist? Hardly.

Mishkin was the co-author of Bernanke's main economics textbook. One of the main points of the book was that central bank policy should be targeting inflation, with upper and lower bands of what the inflation number should be. (Also, I am pretty sure that there was a chapter in that text on the sacrifice ratio.)

So, Ben has a close friend who also believes in inflation targeting. There are a number of other new names on the board of late. Care to make a wager on how they feel about inflation targeting? If you read their speeches, you could certainly be forgiven if you come away with the impression that the recent rise in inflation is their #1 concern.

There is another appointment coming up for a recently vacated spot. Fed watchers should pay close attention to who Bush nominates, as it could mean a major sea change in the way the most powerful central bank in the world operates. This is more than a mere academic exercise of changing one group-think central banker with another. A Fed which openly announces inflation targets is a profoundly different Fed than the one which Greenspan chaired.

And while we are on the topic of inflation, Bill King sent this very interesting note from HSBC's Stephen King & Janet Henry writing on global central-bank vexation over inflation. It succinctly states the problem that I have spent a great deal of time on this year:

"The definition of inflation is crucial. The Federal Reserve's preferred measure has understated inflationary pressures relative to the methodology utilised by the European Central Bank: perhaps the Fed should have been raising interest rates a bit more aggressively two years ago...

"As for measurement, we examine in some detail the different baskets of goods and services that appear in alternative measures of US inflation. Put simply, some baskets contain lots of apples whereas others seem to focus mostly on pears. We reach two broad conclusions. First, the Fed's preferred measure of inflation - the so-called personal consumers' expenditure deflator excluding food and energy - paints the most flattering picture of US inflation trends. Second, the best "early-warning" measure of US inflation is not even widely published: it's the Bureau of Labor Statistic's harmonized measure of US inflation, using the methodology familiar to those who monitor inflationary developments in Europe. This measure was rising rapidly through 2004 when both the CPI and the PCE deflator were barely twitching...

"Perhaps the world economy has an Austrian-style problem. Loose monetary policy in the early years of this decade may have kept the deflationary wolves at bay but, by encouraging excessive gains in asset prices, may have contributed to both excessive consumer leverage and too high a level of global demand.

"If asset prices, notably house prices, now have to fall, they will come down either in nominal terms or, via inflation, in real terms. Central banks determined to stamp on inflation will encourage bigger nominal asset price declines and, by doing so, will raise the risk that current inflationary fears will be replaced by deflationary dangers next year: in response, this year's monetary tightening should be followed by renewed rate cuts in 2007."

The different methodologies of calculating inflation in the US and Europe is a primary reason for Europe showing less GDP than the US over the past several years. The currency market was not fooled. Further, you can bet the Fed governors and economists are aware of these various methods which suggest inflation is a problem. It is just another reason why they sound as hawkish on inflation as they do.

Let me keep beating the same drum I have for the past year. Either the economy slows down, which is not good for the stock market, or the Fed is going to keep raising rates, which is not good for the stock market. Either way, we are going to get to buy back into this market at a much lower place than 11,000 on the Dow.

John Mauldin

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