Will The Fed Go Too Far?
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Economy Rebounded Strongly In January
2. Mixed Signals In The Housing Market
3. Inflation – Still A Problem For The Fed
4. Will The Fed Overshoot & Risk A Recession?
5. Ben Bernanke’s First Time In The Hot Seat
6. Yield Curve Inverts, Or Did It?
New Fed chairman Ben Bernanke testified before Congress for the first time last week, and financial analysts around the world are still debating his remarks, his mannerisms and his differences from his legendary predecessor, Alan Greenspan. But there was little debate regarding where the new Fed chief stands on interest rates. Like Greenspan before him, Bernanke is concerned about rising inflation, and he made it clear that further rate hikes are very likely. The question is, will the Fed go too far and choke off the economy?
The economy is rebounding so far this year following the very disappointing 4Q growth of only 1.1% in GDP. As we ponder the question of the Fed going too far, we need to look at the latest economic reports for January, which so far have been surprisingly strong. In light of the latest reports, some analysts are predicting that GDP could be up 5% (annual rate) or more for the 1Q.
We will also take a look at the latest inflation numbers since we know this is perhaps the ultimate determinant of Fed policy. Wholesale prices hit their highest levels in more than a year in January. While many believe inflation will be a greater problem in 2006, The Bank Credit Analyst has a different view. The editors at BCA believe inflation will surprise on the downside this year, especially in the second half.
In this issue, we will touch all the bases and see if we can make it to home plate in terms of figuring out what’s ahead for the Fed, the economy, the housing situation and the markets. (Yes, it’s baseball season here in Texas, and I am coaching my son’s team again this year; we had our first practice on Saturday, so I’m in the spirit.)
The Economy Rebounded Strongly In January
Not all of the reports for January are out yet, but those we’ve seen so far this month look very encouraging – unless you are the Fed chief, of course, who worries that the economy could get too strong and fuel higher inflation. For starters, consumer confidence hit the highest level in three and a half years in January. This is very good news since consumer spending makes up almost 70% of GDP.
And spend we did in January. Retail sales jumped 2.3% in January, almost three times higher than the pre-report consensus. Consumers went on a post-holiday spending spree, highlighted by huge gift card redemptions. Plus, the unusually warm weather in much of the nation had the shoppers out in droves last month. Retail sales for the 12 months ended January were up 8.8%. Factory output was also up more than expected (+0.7%) in January.
In addition, the Index of Leading Economic Indicators (LEI) rose 1.1% in January. The LEI has been positive in five of the last six months, despite the slowdown in GDP in the 4Q. From July 2005 to January 2006, the LEI has risen 2.3%, which is an annual rate of 4.7%. This also suggests we will see a strong GDP number for the 1Q.
The nation’s unemployment rate fell from 4.9% to 4.7% in January, the lowest level since July of 2001. Over 193,000 jobs were created in January. The government also reported that over the last 12 months, average wages went up 3.3% on a seasonally adjusted basis, the biggest 12-month change in nearly three years.
All of this is very good news for the economy, although as we’ll discuss later, not the best news in terms of the Fed backing off on interest rate hikes.
Mixed Signals In The Housing Market
In keeping with the strong reports above, the Commerce Department reported last Thursday that housing starts surged 14.5% in January, the largest January increase in more than 30 years. Clearly the surge in January was the result of bad weather in December, which postponed many starts, and record high temperatures in January which were ideal for builders. Even if many of the starts in January should have begun in December, the number of starts in January is still impressive.
But other housing indications are troubling. At the top of the list, so far this year, home mortgage applications have fallen to the lowest level in two years. Surging housing starts and falling mortgage applications are not compatible, at least not for long. Even the ever-optimistic National Association of Realtors (NAR) now forecasts that new home sales will decline by 8.5% in 2006, and sales of existing homes will fall by 4.7% this year.
FYI, NAR reported earlier this month that the average price of homes around the country increased by 13.6% in 2005. NAR says the national median home price ended the year at just under $214,000.
I believe that the housing market will continue to cool off as the year progresses, especially if the Fed continues to raise interest rates. Home prices may not fall significantly, but that possibility cannot be ruled out. Even new Fed chairman Bernanke voiced a concern about the housing market in his latest congressional testimony. Given their current lofty levels, home prices and home construction, “could decelerate more rapidly than currently seems likely,” Bernanke said.
While it remains to be seen if the housing bubble ends with a benign slowdown and a flattening of prices, or a serious shakeout with significantly lower prices, I think it is fair to assume that home values will not continue to increase as they have for the last several years.
Commercial and investment real estate is already feeling the pinch of higher interest rates in various parts of the country. I have read reports already this year citing weakness in commercial real estate prices in cities such as Boston, Washington, San Francisco and even Manhattan. This is why I recommended reducing your exposure to speculative real estate and real estate mutual funds last fall. I hope you took that advice.
Inflation – Still A Problem For The Fed
While the economy is flashing strength, and the housing industry is giving mixed signals, the inflation outlook is clearly going in the wrong direction, at least in the short run. Wholesale prices are on the rise. The Labor Department’s Producer Price Index rose 0.6% in December and 0.3% in January. The PPI core rate – excluding food and energy – rose 0.4% in January, the highest rate in over a year.
The Consumer Price Index rose 3.4% in 2005. Clearly, this is higher than the Fed would like. However, the index the Fed is believed to watch most closely is the core rate. In 2005, the core rate of consumer inflation – excluding food and energy - was 2.2%, unchanged from 2004. Most analysts believe the Fed’s target rate for core inflation is in the 1-2% range, and if true, then inflation is indeed above an acceptable rate for the Fed.
As we will discuss below, it’s a virtual certainty that the Fed will raise rates again at the next FOMC meeting on March 27/28. That would put the Fed Funds rate at 4.75%. Analysts are now increasing their odds that we’ll get yet another quarter-point increase at the May 10 FOMC meeting, which would put the rate at 5%.
The current consensus among economists and market analysts is that inflation will continue to be higher than the Fed’s comfort zone of 1-2% in the core rate in 2006. The main question now is, will the Fed feel compelled to raise rates above 5% later this year, especially under the tutelage of a new Fed chairman who is known to be an inflation hawk.
Will The Fed Overshoot & Risk A Recession?
The Fed has a tattered past when it comes to overseeing monetary policy. In the 1970s, the Fed did a horrible job of managing interest rates and inflation. Most of us can remember the days in the late 1970s when inflation was over 14% and gold shot up to $850 briefly during President Carter’s administration. Most of us can also remember the early 1980s when interest rates soared to 16-20% for a brief time, and the recession that followed.
The point is, the Fed has a history of overshooting monetary policy, both on the upside and the downside. Most analysts praise Alan Greenspan for his management of US monetary policy during his 18 years as chairman of the Fed. While I have no particular criticism of Mr. Greenspan, it is true that his tenure as Fed chairman spanned an era of unprecedented growth in the US economy, the biggest bull market in equities in history, and a landmark decline in the rate of inflation.
Likewise, Greenspan’s tenure as Fed chairman included only two recessions, in 1990/91 and in 2001 just after the September 11, 2001 terror attacks. Those two recessions were among the mildest on record. Blessed by a strong economy, the bull markets in stocks and bonds, and falling inflation, Greenspan didn’t have to do much as Fed chairman.
That being said, there is still the history of the Fed over-reacting. As a result, many analysts fear that the Fed will go too far in its current rate hiking cycle and push short-term rates up to a point that economic growth is choked off and a recession follows. What level that would be is anyone’s guess. If the Fed Funds rate goes to 5%, that probably doesn’t send the economy into a recession, barring any major surprise events.
Yet if short rates rise well above 5%, then a recession is certainly possible. It all depends on what happens with inflation and the tenacity of the new Fed chairman.
As I wrote in my January 3 E-Letter, The Bank Credit Analyst believes that inflation will surprise on the downside this year. BCA believes that the continued globalization of the world economy will result in a slowing in the rate of inflation, both in the US and abroad. They expect reduced inflation to become apparent in the second half of this year.
I should point out that BCA, like the Fed, focuses mainly on the core rate of inflation, rather than the Consumer Price Index. As noted above, the CPI rose 3.4% in 2005, while the core rate – minus food and energy – rose only 2.2%. We can argue about whether the CPI or the core rate is the better indicator of inflation; after all, we all have to spend money – and lots of it – on food and energy. Yet it is the core rate which seems to get most of the attention.
So it remains to be seen what inflation will do, and thus how high interest rates will go. Let’s see if there are any clues from the new Fed chairman’s initial congressional testimony.
Bernanke’s First Time In The Hot Seat
As noted in the Introduction, new Fed chairman Ben Bernanke testified before Congress for the first time last week. On Wednesday of last week, speaking before the House Financial Services Committee, Bernanke was quick to point out that he intends to continue with the monetary policy guidelines that Alan Greenspan emphasized. That was widely expected since Greenspan recommended him for the job.
Early on, Bernanke also made it clear that his focus, like Greenspan’s, will be on inflation. Bernanke warned the committee members that inflationary pressures remain high due to high energy prices and the strong economy. Bernanke stated that he believes “the economic expansion remains on track,” despite the slowdown in growth in the 4Q.
The new Fed chief pointed to the tight labor market and rising factory output (capacity utilization) as signs that the economy could overheat this year. Bernanke warned that “output could overshoot its sustainable path, leading to upward pressure on inflation.”
Actually, one would think that higher output would translate into greater supply and therefore lower prices. In reality, it is continued high consumer demand that is more likely to push inflation higher than increased factory output.
Bernanke said the Fed currently expects the US economy to grow by 3.5% in 2006, followed by growth of 3-3.5% in 2007. The Fed also expects core inflation to average 2% for all of this year, at the high end of the Fed’s comfort zone, another indication of more rate hikes to come.
While Bernanke didn’t explicitly say that more interest rate hikes are assured, he did say that more rate hikes “may be necessary” in the coming months. Further, he said the Fed must “make ongoing, provisional judgments about the risks to both inflation and growth.” Most analysts read these statements to mean that at least two more rate hikes lie ahead, one at the March 27/28 FOMC meeting, followed by another at the May 10 meeting.
Bernanke was asked specifically what he thinks about the current rather flat yield curve and the possibility that the curve could invert with additional rate hikes. You may recall that last year Greenspan described the flat yield curve as a “conundrum.” Bernanke said, “Historically, there has been some association between inversion of the yield curve and subsequent slowing of the economy. However, at this point in time, the inverted yield curve is not signaling a slowdown.”
At the end of his congressional testimony last week, most analysts were pleased and somewhat surprised that Bernanke was not even more hawkish on inflation, given his views in the past. Many had expected the new Fed chief to be more hawkish, at least in his rhetoric, than Greenspan. But what they heard was simply more of the same.
The Yield Curve Finally Inverts
We’ve been talking about the yield curve inverting for over a year now. Well, on Friday, the 30-year Treasury Bond closed below the 10-year Treasury Note. The 30-year T-Bond closed at 4.51% versus the 10-year Note at 4.54%. Investors Business Daily has a cover story today entitled: “Yield Inversion Pits Fed Chairman Vs. Bond Watchers Fearing A Recession.”
Many analysts believe the yield curve was already inverted prior to Friday’s market action. For example, the two-year Treasury Note has been above the 10-year and 30-year Treasuries for some time. The two-year Note closed at 4.68% on Friday. So technically speaking, the curve was inverted before last week’s market action.
In any event, you can get ready to hear a lot of talk about the inverted yield curve, especially from the gloom-and-doom crowd. You’ll hear lots of warnings about a recession later this year and next year. In my opinion, the yield curve would have to invert much more significantly to lead to a recession. Finally, it looks like the 30-year bond is climbing back above the 10-year Note in trading today.
The economic reports we have seen so far this month indicate that the 1.1% growth in GDP in the 4Q was an aberration, due mainly to the hurricanes and soaring energy prices, rather than a trend toward slower economic growth. Based on these early reports for January, some analysts (including Dr. Ed Yardeni) are now predicting that 1Q GDP will be as high as 5%.
It remains to be seen what is happening in the housing market. While housing starts were much higher than expected in January, mortgage applications have fallen to the lowest level in two years since the beginning of this year. I continue to believe that the housing boom is peaking, as is commercial real estate. It is too early to know if this is the bursting of the bubble, with a big fallout, or simply a pause in the long-term trend.
Clearly, the rate of US inflation (3.4% in 2005) is higher than the Fed wants to see. The core rate of inflation – minus food and energy – was 2.2% in 2005, which is slightly above the Fed’s supposed comfort zone of 1-2%. This argues for more interest rate hikes in the next few months.
New Fed chief Ben Bernanke offered no surprises in his maiden testimony before Congress last week, other than the fact that he answered questions rather directly, as compared to Greenspan. Without saying so specifically, his comments suggest there will be at least two more interest rate hikes in late March and early May.
Beyond that, the outlook for Fed monetary policy is as clear as mud. Will Bernanke and his fellow curmudgeons at the Fed repeat history and overshoot on the upside? Will they risk a recession in order to keep inflation in check? That remains to be seen.
The Bank Credit Analyst continues to believe that inflation will surprise on the downside, especially in the second half of the year and beyond. If this is the case, then the Fed may be done raising short-term rates after the May 10 FOMC meeting.
At the end of the day, the stock and bond markets seemed to like what they heard from the new Fed chairman. Stocks moved to the highest levels since June 2001, with the Dow clearing 11,000 comfortably. Treasury bond futures closed higher on the last day of Bernanke’s testimony as well. Gold is well off of its recent highs.
The behavior of these markets does not suggest that inflation is about to get out of control, nor that the Fed is going to significantly overshoot on the upside. What we may well see is more of these choppy markets, which argues for “active management” strategies that have the flexibility to hedge or go to cash if market conditions warrant.
If you are having difficulty navigating today’s choppy market environment, give us a call at 800-348-3601 and get professional money management on your team.
Very best regards,
Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.