Fed Watching Finally Gets Interesting Again

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
November 29, 2005

IN THIS ISSUE:

1. Fed Considers A Change In Monetary Policy

2. Fed Watching Should Be More Interesting

3. Ben Bernanke – Another Fed “Maestro”?

4. The Economy Surprises On The Upside

5. Holiday Shopping Off To A Good Start

6. More Bad News For The Housing Industry

Introduction

On November 1, the Federal Reserve’s Open Market Committee (FOMC) raised the short-term Fed Funds rate for the 12th consecutive time, from 3.75% to 4%, much as expected. In the policy statement that accompanied news of the latest quarter-point rate increase, the FOMC continued with its well-known language suggesting additional rate hikes in the future at a “measured pace.”

The ‘measured pace’ language is assumed an assurance, more or less, that the next increase will be another 25 basis points, and not something greater. So analysts read the FOMC’s statement on November 1 to mean we will get another quarter-point increase on December 13 when the FOMC next convenes, thus pushing the Fed Funds rate up to 4.25%. No surprise there, nor will there be a surprise if the Fed Funds rate is increased to 4.5% in late January.

However, on November 22, the Fed released the minutes of its November 1 FOMC meeting, and if you read them carefully, there is an indication that the Fed is now considering a change in policy. The FOMC members are now thinking of how and when to stop raising rates. This is significant.

Interestingly, I have seen very little discussion regarding this possible change in policy by the Fed. I assume that when most Fed watchers in the media saw the ‘measured pace’ language in the FOMC’s statement on November 1, they didn’t bother to read the minutes from that meeting which were released publicly on November 22. So, in the pages that follow, I will discuss the latest thinking by the Fed and what it may mean.

Following that discussion, I will reassess the US economic outlook. In short, the economy grew considerably stronger in the 3Q than expected, with GDP expected to have risen to 4.1% (annual rate), up from 3.8% previously reported. And the holiday shopping season is off to a better than expected start. All this suggests that the economic slowdown as a result of the hurricanes will not be nearly as bad as expected.

We have a lot to cover, so let’s jump right in.

Fed Considers A Change In Policy

As noted above, the FOMC raised the Fed Funds rate for a 12th consecutive time at its November 1 policy meeting, from 3.75% to 4%. No one was surprised. The FOMC also continued with its suggestion of additional rate hikes at a measured pace. This is the very same language the Fed has included with each of the previous 11 rate hikes. We’ve all gotten so used to it, and so have the financial markets. Ho hum.

However, on November 22, the Fed released the actual minutes from the November 1 FOMC meeting. Fed watchers usually peruse these minutes carefully to see if there is anything unusual or different to be found in the details of what was discussed by the monetary policymakers. While I have seen few comments in the media, the FOMC minutes suggest to me that the Fed is considering how to change its ‘tone’ and perhaps when to end the rate hiking cycle.

It is no secret that the Fed’s primary goal with regard to monetary policy and interest rates is to keep inflation in check. Most Fed watchers agree that the FOMC would like to see consumer price inflation at or below 3%, and preferably closer to 2%. Inflation based on the Consumer Price Index has been running well above 3% this year; in fact, as of October, the CPI was up 4.3% over October 2004. However, this is largely due to big increases in energy and lesser increases in food prices.

Most Fed watchers agree that the FOMC focuses far more on the “core rate ” of inflation than on the actual CPI numbers. The ‘core rate’ is the CPI minus food and energy. The core rate of inflation is typically quite different from the broader CPI. The core rate of inflation was up only 0.2% in October and was up only 0.1% in the five preceding months.

With the core rate of inflation in a very comfortable zone, it is not surprising that some members of the FOMC wanted to talk about how and when the Fed might end this long rate hiking cycle that began on June 29, 2004. While the members voted unanimously to raise the Fed Funds rate to 4% on November 1, there was some interesting discussion about the future. Here’s a sample:

“Soaring energy prices have boosted overall measures of consumer price inflation in recent months. However, measures of core consumer price inflation were much more restrained. The twelve-month change in core consumer prices through September was about unchanged from its year-earlier level.

… all members believed it important to continue removing monetary policy accommodation [raising rates] in order to check upside risks to inflation and keep inflation expectations contained, but noted that policy setting would need to be increasingly sensitive to incoming economic data. Some members cautioned that risks of going too far with the tightening process could also eventually emerge.

In their ongoing discussion of the Committee's communication strategy, participants expressed a variety of perspectives about how the policy statement issued at the end of FOMC meetings might evolve over time. Several aspects of the statement language would have to be changed before long, particularly those related to the characterization of and outlook for policy. Possible future changes in the sentence on the balance of risks to the Committee's objectives were also discussed.” [Emphasis added, GH.]

Interpreting “Fed-speak” such as that above is frequently more of an art than a science, and any interpretation is open for question. However, the discussion above is unusual as compared to previous FOMC meetings this year. It is clear that certain members of the FOMC are beginning to think about an end to the rate hiking cycle that began with the Fed Funds rate at 1%.

Some FOMC members are even expressing concerns that the Fed might go too far in hiking rates, which could lead to an economic slowdown. The Fed has a long history of over-reacting in monetary policy – both on the upside and downside. You may recall that Greenspan was criticized for raising rates too much in the late 1990s.

Fed Watching Gets Interesting Again

I don’t know if “Fed watching” should ever be considered truly interesting, but it has certainly been anything but interesting over the last year or so, what with the same quarter-point increase and the same ‘measured’ language every six weeks or so. Based on the minutes from the latest FOMC meeting on November 1, however, it does appear that the Fed is at least considering how and when to change course. So at least it will be somewhat more interesting to watch what happens going forward.

What we can conclude from this is as follows. First, the FOMC will continue to focus on the inflation rate, and especially the ‘core rate.’ Second, how and when the FOMC will change policy will depend in large part on how the economy is doing, and as I will discuss below, the economy is once again surprising on the upside. Third, the most likely scenario is that the Fed will begin this shift by first changing the policy language to something other than “measured” increases before going to a neutral position. There has been a lot of speculation as to what the FOMC might substitute for the word “measured.”

The next FOMC meeting is on December 13, with another to follow on January 31 when Alan Greenspan retires as Fed Chairman. Some Fed observers, including The Bank Credit Analyst, believe there is a good chance the FOMC will raise rates again at the Dec 13 meeting, but change its policy language to something other than ‘measured.’

That, some believe, would pave the way for the FOMC to raise rates a final time to 4.5% in late January as Greenspan chairs his final meeting as the Fed’s “maestro.” This of course will depend greatly on what the economy is doing at the time. If the economy continues to surprise on the upside through the end of the year, then more rate hikes may be in store.

Ben Bernanke – Another Fed Maestro?

It is widely expected that Ben Bernanke will be confirmed as the next chairman of the Federal Reserve Board. Since he will be replacing an often-called “legend” in Alan Greenspan, I thought you would be interested in a brief look at Bernanke’s background.

Bernanke, age 51, was born in Georgia, the son of a pharmacist and schoolteacher. The family later moved to Dillon, South Carolina where he first began to exhibit his enormous intellectual capabilities. In the sixth grade, he won the state spelling bee, and then went on to high school where he taught himself calculus and scored 1590 of a possible 1600 on his SAT.

Bernanke continued to shine intellectually at Harvard University, where he graduated summa cum laude in 1975. He then went on to receive his PhD in economics from MIT. After receiving his PhD, he moved immediately into the teaching field as a professor at Stanford University. He later moved to Princeton where he rose to the position of chairman of the economics department.

Bernanke says that he always thought he would spend his career as a professor, but that all changed in 2002 when he was selected as a member of the Fed Board of Governors, where he served until 2004. Most recently, Bernanke has served as the chairman of the president’s Council of Economic Advisors.

One might think that such an intellectual heavyweight might not have the interpersonal skills necessary to serve as the Fed chairman, but such is not the case. While friends and acquaintances all acknowledge Bernanke’s intellectual prowess, they also praise his interpersonal skills, and his ability to build consensus. This will be extremely important in his position, as he will need to gather support from the other board members as well as in the 12-member Federal Open Market Committee.

Bernanke has always been praised for being able to de-mystify complex economic issues and present his position with great clarity. Fed watchers around the globe are interested to see whether he will continue to speak with his characteristic clarity, or begin to use the often-confusing “Fed-speak” as practiced by Alan Greenspan.

While Bernanke is a Republican, he is considered to be a moderate, which may help his nomination. Many of his colleagues state that they have no idea where he stands on many controversial issues that tend to separate the political left from the right. But given that he will head-up the Fed (and not some political office or federal court), his personal views on issues may not be much of a factor.

Bernanke has authored numerous books and articles on economic issues, and is a frequent speaker on such topics. He is considered to be one of the foremost experts on the subject of how central banks such as the Fed should set interest rates and control money supply. In November of 2002, Bernanke stirred some controversy by suggesting that the US should never experience deflation as long as the government has the ability to print money.

Bernanke also advocates “inflation targeting” where the central bank puts top priority on keeping the annual increase in consumer prices to a minimum target level. He has said that he believes 2% is the appropriate number as a target. So not a great deal of change there.

A confirmation hearing on Bernanke’s appointment was held on November 15 th, where he received little more than token partisan resistance from Democrats who want to look good to their constituencies back home. This is no big surprise since he had already been through three Senate confirmation hearings for his appointments to the Fed and White House positions. Most believe that he will be confirmed as the new Fed chairman by the end of the year, or if not, before the FOMC meeting on January 31 when Greenspan retires.

The Economy Surprises On The Upside

While the media coverage of the economy is ever-negative, the US economy is surging despite the effects of the three ravaging hurricanes. The latest report on Gross Domestic Product growth – due out tomorrow (Wednesday) – is expected to show the economy boomed in the 3Q, again despite the effects of the hurricanes. Based on recent economic reports, the consensus forecast now is for a 3Q increase from 3.8% to 4.1% in tomorrow’s GDP report. That follows growth of 3.3% in the 2Q.

Should GDP come in at 4% or above for the 3Q, this will be another example wherein the US economy surprised on the upside as it so often has over the last decade. Given the sharp decline in the Index of Leading Indicators (LEI) in August and September, and the plunge in consumer confidence after the hurricanes, most economists expected a much weaker 3Q GDP number.

On the bright side, the Consumer Confidence Index published by the Commerce Department showed a mild uptick in October and then soared this month. The Index rose from 85.2 in October to 98.9 this month, the strongest monthly gain in over two years. The University of Michigan’s Consumer Sentiment Index showed a similar modest increase in October, but had a significant jump from 74.4 to 81.6 in November.

It remains to be seen how the economy fares in the 4Q. The largest decline in the LEI and consumer confidence occurred in September, so there is still the possibility that the 4Q GDP number will be below the 3Q rate which we will see tomorrow. However, absent a major surprise in the next month, I think it is safe to conclude that the economy is not going to slow down as much as most analysts (myself included) predicted just after the hurricanes.

Holiday Shopping Off To A Good Start

Early indications are that US retailers, in general, saw a better than expected start to the holiday shopping season over the weekend. Depending on which group you read, retail sales after Thanksgiving were either just shy of last year’s levels, or just above. Either way, that was much better than had been expected just after the hurricanes.

According to ShopperTrak, which monitors sales at over 45,000 retail outlets across the country, sales for the Friday-Saturday period were down 0.5% from last year. Walmart, on the other hand, reported that sales were up and predicted an overall increase of 4.3% over last year for the month of November.

Last week, the National Retail Federation raised its sales forecast from 5% to 6% year-over-year. That compares with a 6.7% rise in retail sales in 2004. Still, that’s a healthy increase, what with the hurricanes, and gasoline and heating oil being much higher this year than last.

It is clear that retailers are having to discount merchandise more heavily this year than last. While sales and steep discounts were widespread over the weekend, that will not be good for retailers’ bottom lines. Many in the industry predict that price wars will erupt well before Christmas. So, not only will profit margins be thinner, expenses will be higher as most stores are remaining open for longer hours.

Retail stocks in general have been very strong over the last couple of months. If you are heavily positioned in this sector, you might want to take some profits and reduce your exposure.

More Bad News For The Housing Industry

There continue to be increasing signs that the housing boom has turned the corner. Sales of existing homes fell 2.7% in October according to the National Association of Realtors (NAR). The inventory of existing homes on the market also increased from 2.9 million homes to 3.5 million in October. The NAR also reports it is taking longer to sell homes. Housing starts fell 5.6% in October, the lowest level in five months. The NAR also reported that sales of condos and cooperative housing fell 4.4% in October.

Certainly, the bubble hasn’t burst yet, with record new home sales the median new home price rising 1.6% to $231,000 according to the NAR. But more and more indicators, such as those noted above and others, suggest that the housing market is topping out. Ditto for real estate in general.

The CBOE Dow Jones REIT Index fell sharply in August and September in the wake of the hurricanes. It has since recovered more than half of that loss since early October. I hope you have taken my advice to lighten-up in speculative real estate and REITs. If you still need to reduce exposure to REITs, the recent rebound provides another good opportunity to do so.

Conclusions

The Fed is at least considering a change in monetary policy, as confirmed by the minutes of the November 1 FOMC meeting. The “core rate” of inflation (minus food and energy) has been quite low and steady for the last six months, despite the effects of the hurricanes. So, some members of the FOMC are suggesting it is time to think about how and when to halt the interest rate hiking cycle that began in mid-2004. At least one member fears the Fed may go too far and choke-off the economy.

Some, including BCA, have suggested that the Fed may raise rates a quarter-point on December 13 and a final time on January 31 when Greenspan retires. Whether or not the Fed ends the rate hikes in January will depend on how the economy is doing. The economy surprised on the upside in the 3Q, and the latest GDP report tomorrow is expected to confirm that.

There are others who speculate that when Ben Bernanke takes over at the end of January, he may feel compelled to raise rates one last time on March 28, just to show the markets that he is committed to fighting inflation. Could be, but I think his record is strong enough that he does not need to send a token sign to the markets. Again, the economy will be the driver for when the Fed takes a break.

Even though holiday retail sales have started stronger than expected, I continue to believe that GDP growth in the 4Q will be less than in the 3Q (but of course we won’t know that until early next year). If the economy continues on a roll, then the Fed will likely be inclined to continue raising rates next year.

In any event, with a possible policy change at least on the table, and the retirement of Alan Greenspan in late January, Fed watching will be at least a little more interesting than it’s been for the last year or so.

Happy Holidays To All!!

I hope everyone had a great Thanksgiving! We had a total of 17 family and friends at the Halbert House, complete with two turkeys, ham, dressing, gravy (all prepared by yours truly) and all the assorted trimmings. A good time was had by all.

Debi and I will travel to New York City late this week for a combination of business and pleasure. We are excited because neither of us has been to the Big Apple during the holidays. We are looking forward to seeing all the holiday decorations, the Rockettes’ Christmas show at Radio City, ‘Dirty Rotten Scoundrels’ on Broadway and plenty of quality time with some dear friends.

That’s all for this week. I hope you are in the holiday spirit!

Very best regards,

Gary D. Halbert

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