DEAR ALAN, AFTER THE ELECTION… PLEASE

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
February 10, 2004

IN THIS ISSUE:

1. Will The Fed Raise Rates Before The Election?

2. The Economy – Can The Fed Afford To Wait?

3. Fed Changes Policy Language -- Just In Case.

4. BCA On When & How Much Rates Will Go Up.

Introduction

With the economy growing very solidly now, should Alan Greenspan & Company at the Fed raise interest rates in an election year? Most economists say yes – the Fed should raise rates at least slightly now that the economy is booming, to keep inflation in check. But guess what? Normally, the Fed doesn’t raise interest rates in presidential election years. The Fed prefers to be politically neutral to the extent that it can.

But can the Fed sit idle in 2004, just because it’s an election year? The economy was on fire in the last half of 2003. GDP exploded at an annual rate of 8.2% in the 3Q, followed by 4% in the 4Q (average: 6.1% in the last six months). Normally, when the economy grows this rapidly, rising inflation follows. Thus, most economists believe the Fed will have to raise interest rates this year.

If the Fed raises interest rates modestly in the next few months, it should have minimal effects on the economy, but it would send a major negative signal to the investment markets. We saw evidence of that earlier this month when the Fed merely changed its policy language regarding when rates might go up (see below), and stocks headed south.

The presidential election race has tightened significantly, and Alan Greenspan (who is an old friend of VP Dick Cheney) knows very well that the economy is the number one issue on most voters’ minds. So he would very much prefer to leave rates alone this year. Yet it’s seven months until the election, and the Fed’s latest action has opened the door to a rate hike. So what gives? This week, we look at these issues.

The Economy Vs. The Fed’s Target

The US economy, as measured by the Gross Domestic Product, soared at an annual rate of 8.2% in the 3Q. Had this rate continued in the 4Q, the Fed almost certainly would have already raised interest rates. Yet GDP growth cooled to a 4% annual rate in the 4Q. The Fed’s target for “non-inflationary” economic growth is 3-4%. As long as growth is within this range (or lower), higher inflation should not be a problem and hence, no need for higher interest rates.

The question is, will economic growth remain within the Fed’s target range? Let’s quickly review some recent economic data. As noted above, the economy grew at a 6.1% annual clip in the second half of the year. GDP for all of 2003 was 4.3%, slightly above the Fed’s non-inflationary target. The Index of Leading Economic Indicators (a good barometer) has risen mildly in the last three consecutive months; since its low last March, the Index has expanded at an annual rate of 4.7%, also above the Fed’s target.

Consumer spending accounts for over two-thirds of GDP. Consumer spending increased briskly in the last two months of 2003. Retail sales rose 5.6% in 2003 over 2002 levels, again above the Fed’s non-inflationary target. The Consumer Confidence Index rose again in January and is now at the highest level in 18 months.

On the manufacturing side, the news is also strong. The Institute for Supply Management (ISM) reported that its manufacturing index rose again in January for the eighth consecutive month. Construction spending also rose briskly over the last two reporting periods. The housing sector also continues to boom. New home sales hit an all-time record in 2003, with over 1 million homes sold, up 11.5% over 2002.

In January, the unemployment rate fell for its fifth consecutive month to 5.6%, the lowest level since October 2001. The job market has been slow to turn the corner, but this is normal following recessions. Job growth should be considerably better in the months ahead, despite all the rhetoric to the contrary in the campaign.

Almost all of the data above suggest that the economy is growing at a rate above the Fed’s non-inflationary target. This would suggest a rate hike before the election. But first we should look at the inflation data specifically.

Inflation Data Holds Mixed Signals

Even though the US economy flirted with deflation during the recession, the Fed remains very focused on keeping inflation under control. By most measurements, inflation remains fairly benign, even with the strong recovery in the economy. In 2003, the Consumer Price Index rose only 1.9% following a rise of 2.4% in 2002. The so-called “core” rate of inflation (excluding food and energy) was 1.1% in 2003. The GDP “Price Deflator,” another measure of consumer inflation, also rose only 1.9% in 2003.

Wholesale prices, on the other hand, rose 4% in 2003 as measured by the Producer Price Index (PPI), following a rise of 1.2% in 2002. Excluding food and energy, however, the PPI rose only 1% last year.

On balance, the latest inflation data doesn’t suggest a serious problem for the Fed. On the other hand, commodity prices have risen sharply over the last year, and gold has been in a major bull market. The rise in these markets has been attributed to the falling dollar, which could also indicate that higher inflation is coming in the months ahead.

Fed Drops “Considerable Period” Language

The Fed Open Market Committee (FOMC) meets every six weeks or so to set monetary policy. While these meetings are held in private, the minutes are made available to the public. These minutes are scrutinized by analysts all over the world for any signs of a change in interest rate policy.

The last FOMC meeting was held on January 27-28. For most of the last year, the FOMC minutes have included language indicating that the Fed intended to keep interest rates very low (currently 1% in the Fed Funds rate) for a “considerable period.” But in the January meeting, the FOMC members decided to change that language and replaced it with the following: “…the Committee believes that it can be patient…”

So, what’s the difference between leaving interest rates unchanged for a “considerable period” and being “patient?” On the surface, not much. Yet anytime the Fed changes its carefully chosen policy language, the markets sit up and take notice. The stock markets fell sharply just after the latest FOMC minutes were released as analysts fretted that the Fed might be about to raise interest rates.

The latest language change shouldn’t have surprised anyone. Some analysts expected the Fed to change the wording at the December FOMC meeting. Yet even though such a change was expected, the markets reacted negatively anyway. The fact is, the Fed will have to raise interest rates at some point, and some argue they should have already done so. Given the response in the equity markets to the Fed’s minor language change in January, it is probably safe to assume that stocks will get hit even harder whenever the Fed does finally raise rates.

Can The Fed Afford To Wait Until After The Election?

This is a big question among market analysts. But there is no way to know at this point. That decision will depend on the economic data we see over the next couple of months. If growth remains above the Fed’s non-inflationary target, then we could well see a bump in rates before the election. On the other hand, if growth continues to slow from the levels seen in the second half of last year, Greenspan & Company will be happy to leave things alone. We just have to wait and see what the upcoming reports show.

Here is the latest thinking from the widely respected editors at The Bank Credit Analyst. They continue to believe that the Fed will raise rates this year.

“The FOMC dropped the term ‘considerable period’ from its recent post-meeting statement, but it continues to imply that there will be no early shift from the current accommodative stance. Although economic growth is strong, the Fed will not be happy until employment picks up and inflation moves higher. Nonetheless, the Fed has extricated itself from the constraints implied by its ‘considerable period’ language, giving it more flexibility to respond to continued positive economic surprises [BCA-speak for raising interest rates].

The inflation outlook is critical to the timing of a Fed move. The core inflation rate dropped to 1.1% at the end of 2003, a new 40-year low. The Fed does not have an explicit inflation target, but the comfort zone is probably about 2%. Until inflation stops falling, the Fed feels it can afford to be patient.

The first rate hike could still occur at mid-year. The market attaches a 70% probability to a 25 basis point rate hike in the next six months. A lot can change in the space of a few months and, assuming employment recovers as we expect, the Fed will start to be more forward looking. The Fed will not want to alter policy within a month or two of the November elections…

While the Fed will probably start to tighten this year, the end-2004 fed funds rate is unlikely to exceed 2%.”

Sooner Rather Than Later

All of this leaves the Fed in an uncomfortable position. On the one hand, the economy seems to be trending toward a non-inflationary pace, and most (not all) of the inflation data look fairly tame. On the other hand, upcoming economic reports could certainly surprise on the upside again, as could inflation. Only time will tell.

But above all, the Fed does not want to have to raise interest rates as the election approaches. Greenspan does not want to be accused of playing politics with monetary policy. Maybe he and the other FOMC members will decide to get it over with sooner rather than later.

The next scheduled FOMC meetings are on March 16, May 4, June 29-30, August 10, September 21 and November 10. My bet is that a rate hike will come after the May meeting, if they are going to raise rates this year. That gives the Fed over two months to watch the economic data and make a decision. I don’t see them raising rates this summer when the country is in election mode. I could be wrong, of course.

As BCA suggests, the first rate hike will likely be only a quarter-point (25 bps) increase. And it is widely expected. So it should not have any major market implications, right? Not so fast. If the markets’ reaction to the late January change in the “considerable period” language was any indication, both stocks and bonds could take a more serious hit whenever rates actually go up.

Investment Implications

A LOT of money is pouring back into the stock markets. January saw near-record levels of purchases of equity mutual funds. This comes right on the heels of the big stock market gains seen in 2003. The average equity mutual fund gained 30% last year. And investors are herding back into the funds, hoping for another repeat.

With so much money still sitting in money market funds (an estimated $5 trillion at the end of last year), there is a lot of new buying potential that could come in. Thus, it is possible that stocks could surprise on the upside again this year. Yet I will be surprised if the equity markets are nearly as kind to investors as they were in 2003. If interest rates go up, it will not be positive for stocks in general.

FYI, there have been nine bear markets in stocks since WWII. The S&P 500 Index rose an average of 36.1% in the first year following the end of those bear markets. In 2003, the S&P 500 Index rose 28.7%, fairly consistent with historical standards.

More importantly, in the second year following bear markets, the S&P 500 gained an average of only 8%. This doesn’t mean stocks can only go up 8% in 2004; it just means the risks are higher now after following the big year in 2003.

This is why I continue to recommend using professional mutual fund Advisors that can either “hedge” their long positions or move partly or fully to the safety of money market accounts if the stock markets head lower. Ditto for bonds.

You can CLICK HERE to see the professionally managed programs I currently recommend. Or you can call us at 800-348-3601 for more information.

All the best,

Gary D. Halbert

P.S. Let me warn my Republican/conservative readers that the last two stories in “Special Articles” below are very critical of President Bush. While I voted for Bush in 2000 and will vote for him again this year, I am very disappointed with his record on spending.

SPECIAL ARTICLES

Good news on WMDs & nuclear proliferation.

A conservative criticizes Bush for big spending.

More criticism of Bush’s big spending (a long read).