February 2, 2005
What is The Fed Really Fighting?
By Brady Willett

It is generally held that the Fed will raise interest rates today to fight inflation.  Given that the Fed is responsible for causing inflation (i.e. under a gold standard prices remained generally stable), we should not cheer Greenspan and Co. for their efforts.  Rather, a more fruitful goal for the investor is to query what type of inflation the Fed is attacking today, and what asset classes are likely to be negatively impacted during the Fed vs. Inflation war.

To begin with, consumer prices are running hotter than the Fed would like, and at an annual rate that is above the Federal Funds rate. As a result, the consensus is that in order to achieve neutrality – meaning a Fed Funds rate that neither stimulates nor holds back the economy – the Fed needs to hike the Federal Funds rate to around 3%.  Although some are predicting that a strong U.S. economy/rising price inflation will force the Fed to continue raising interest rates north of 4%, there is little debate on the fact that the Fed is still looser than it needs to be: the ‘accommodative’ gap between inflation (CPI) and the Federal Funds rate is aptly demonstrated in the following chart.


If you focus on the CPI the Fed looks like it is behind the curve, yet perhaps still on pace to catch up given that the U.S. economy is slowing down. But if you focus on commodity prices or asset prices (home prices), the Fed looks as if it is out to lunch.

Since the governments’ take on prices leaves (out) much to be desired, commodity prices could be a more reliable indicator of future inflation trends.  However, there are reasons to believe that rising commodity prices are overstating the inflationary threat.  For example, U.S. industrial capacity is not nearly tight, and yet commodity prices are booming. 


The astute global watcher could counter that U.S. capacity is not as high as it historically is at this stage of ‘recovery’ because companies are shifting more of their production needs to places like China. In other words, if you want to know when commodity prices will cool or heat up keep a keen eye on anything to do with China, and ignore U.S. capacity statistics. A chart from Clarkson Research sums up the hot Chinese story.


While irrefutable – China has developed a seemingly unquenchable thirst for coal, oil, steel, etc. - it is worth noting that another reason for the commodities boom is the slumping U.S. dollar.  An example of this is seen when you compare the CRB to the CRB priced in Euros or Gold.
 


In sum, the depressed dollar and China’s rampant demand for goods - which is being partially supported by the American economic recovery - are boosting commodity prices.  The CPI is also running a little hot for the Fed’s liking.  

The Other Inflation Angle

The other inflationary theme is asset prices.  In the December Fed minutes the Fed talked about this theme in detail:

“Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums.”

Since December 14, 2004 there has been an orgy of mergers and acquisition activity, housing activity and home prices have continued to heat up, and credit spreads have failed to widen. In fact, the only financial market that seems to be paying any attention to the Fed is the stock market.  It goes without saying that the Fed is still worried above ‘excessive risk-taking’ in the markets.

So, what is the Fed really fighting?

The Fed has so much on its plate these days I wouldn’t dare offer a concrete answer to the above question.  What can be said, however, is that the ‘bad loans are made during good times’ adage is almost certainly what the Fed is thinking about today. Quite frankly, when times are ‘good’ – as they are today – the Fed must acquire the ammo it needs to combat the eventual bad times. 

That said, with a gun to my head I would have to say that the Fed is most concerned with risk taking in the markets.  Specifically, the Fed is worried that the U.S. housing market is a disaster waiting to happen.  Quite frankly, if the Fed fails to thwart excessive leverage/speculation in the housing market today and an unexpected crisis arrives tomorrow (i.e. the Fed has to cut interest rates in an emergency situation), there is no telling how far the U.S. homeowner will go to borrow spend if mortgage rates declined further. In other words, the Fed is worried that if the U.S. economy grows even more reliant rising home prices/unprecedented home refinancing the inevitable bust will be that much more severe. 

Which leads us to why long-term interest rates (avoiding conspiracy theories) have failed to rise in the face of 5-rate hikes: the Fed is not attacking price inflation!   Rather, and despite the commodities bull, price inflation is largely contained.  To be sure, none of the traditional indicators (wages, jobs, capacity, inventories, etc) are suggesting that a major long-term inflationary threat is emerging.  Instead, the boom in China and the slumping U.S. dollar have temporarily overstated the inflationary threat.

As for the argument the inflation is a real threat, this theory suggests that the U.S. economy is in a sustainable long-term recovery.  After all, how conductive is China without increasing demand from America? I don’t buy into this theoy, and if long-term interest rates move higher and stall the U.S. economy no one else will be buying this theory either.

* If the dollar collapses (which would be inflationary), U.S. interest rates would likely spike higher.  Rising interest would quickly bust the refi/debt reliant U.S. economy. This scenario - assuming the dollar doesn’t turn to dust - suggests stagflation rather than raging inflation/hyperinflation.

Incidentally, there are two things that will make the Fed get more aggressive:

1) The U.S. dollar crashes.
2) Job creation explodes higher.

If the dollar and job creation hold steady the Fed will continue to raise interest rates until risk taking is backed out of the markets.  As for when the Fed’s tightening campaign will come to end, like love, you will just know.

Conclusion

The last time the Fed strung together six rate hikes in a row was from June 30, 1999 to May 16, 2000.  The U.S. stock market mania met its peak during this tightening phase, as did the longest U.S. expansion on record.  The optimists that ignored the ‘don’t fight the Fed’ mantra back in 1999 rationalized that the first three rate hikes in 1999 where simply the result of the 1998 rate cuts being taken back.  By the time the last three hikes arrived the mania was all but over.

In the first 5-months of 2000 the U.S. economy erected more than 1.3 million new jobs (274K average per month).  If by some miracle jobs can be created at this pace in 2005 the Fed will start throwing in the odd 50bp rate hike (as it did in May 2000 even as stock prices were declining).  If not expect 25bp until the financial markets learn to respect their master. Incidentally, ‘Don’t fight the Fed’ is one of those rare Street adages that Wall Street always seems to ignore. Who has time to fight the Fed when there are so many M&A deals to close and so many fund dollars to throw around in the financial markets?