UNDERWRITING EXUBERANCE. . .
And HOPING for Inflation
Chris Temple, Editor/Publisher
The National Investor
www.nationalinvestor.com
May 20, 2004
On Tuesday, May 4, we were treaded to the Federal Reserve's latest word games over its future intentions regarding monetary policy. Following its meeting, the Fed's Open Market Committee suggested that-yes, indeed-it will finally start raising interest rates one of these days. However, when it gets around to taking away its "policy accommodation," of short-term interest rates at their lowest levels in nearly half a century, the central bank said it would do so "at a pace that is likely to be measured."
Initially, the appearance of a central bank still hesitant to take away the punch bowl soothed the financial markets (actually, it will end up being more likely that this Fed will merely be spiking it less, rather than taking it away.) Bonds and stocks both held their own in the immediate aftermath of the Fed's latest missive. Since then, however-especially when a second straight payroll employment report seemed to imply that the Fed is every bit as much "behind the curve" as its noisiest detractors insist-markets were bleeding red once more. As I'll detail further along in this issue, stocks and bonds (especially Treasuries) both swooned.
For some time now, especially with interest rates rising elsewhere in the world (the U.K., Australia and New Zealand most notably, all to slow down the kind of housing and credit excesses the Fed has gleefully been supporting,) anxiety has been growing over the Fed having little choice but to play catch up one of these days. Though it has not raised interest rates, the European Central Bank has moved away from lowering them now, as both inflation (primarily due to energy prices) and growth in the euro-zone have ticked up a notch or two. Increasingly, the Fed seems isolated; and especially after a few months' worth of inflation and economic growth numbers pointing almost unanimously to the need for the Fed to abandon its "emergency" federal funds rate of 1%, that it still seems unwilling to do so has some people nervous.
Following the F.O.M.C. meeting, opinions were naturally being put forward energetically as to what the Fed should have done. Most bemoaned the fact that, as CNBC's Steve Liesman put it, the "Chinese Water Torture" will continue indefinitely. We'll go from meeting to meeting in suspense; and even after the Fed starts raising the federal funds rate in 25-basis point increments, we still won't know where we're going to be ending up.
Larry Kudlow insisted we're in a "boom" that would actually be helped out if the Fed got some backbone and started raising rates in half-point chunks; something he insisted would actually benefit the market. Of course, Kudlow would be bullish on stocks if NASA announced an asteroid was about to hit the Earth…but I digress.
PIMCO's Paul McCulley, while not going that far, suggested that the Fed needed to give us some clarity as to what its expected outcome will be. Will they soon consider a funds rate of 2.5-3% neutral? 4%? Granted, nobody can predict the future with great accuracy; not even Chairman Greenspan. But a Fed seen as reactionary and slow, rather than the more deliberate and self-assured one pined for by McCulley, doesn't really help us all that much.
His colleague Bill Gross-manager of the largest baskets of bond portfolios known to mankind-has become downright cynical. He's been convinced for a while now that the bond bull market has peaked. He also feels that, thanks to the Fed's "policy accommodation," inflation has not only escaped out the barn door, but is already in the neighbor's pasture. Following the F.O.M.C.'s "chicken" announcement, an incredulous Gross suggested that anyone hearing his voice "move money to a central bank in euroland that is more rational."
Rational or otherwise, these folks don't seem to sufficiently appreciate that the Federal Reserve is something else too-scared silly. No, folks, the Fed is not completely clueless; maybe only partially so. The fact is, it feels it cannot afford to tighten monetary policy for fear that its actions will devastate leveraged consumers, a leveraged bond market, stocks and all the rest. Having underwritten exuberance for so long-and moved toward its real objective of inflationary growth-it feels it cannot turn back; and that, once it does, it must still keep an inflationary bias in its policy, even if it dare not admit it.
In the end, of course, a fractional reserve system is guaranteed to bring unpleasantness. In our case, much of the unpleasantness that should have followed the stock market bubble's breaking in 2000 did not occur. Instead, the Fed-after reversing course after some rate hikes that year-has had the pedal to the metal, drowning the country (and the world) in a rising sea of dollars in an effort to keep the economy in tact.
Particularly following its last couple rate cuts, and throwing in some good benefits from last year's tax cuts, Greenspan's elixir has seemed to work nicely; more so than many imagined possible. Stocks steadily moved higher. Confidence (i.e.-the willingness to take on even more debt) recovered as well. The Fed's accommodation reinvigorated and loosened up capital markets that had become rather tight in 2001 and 2002. In short, Greenspan has made a lot of Americans feel we're back to the good old 1990s again.
But in spite of the fact that the economy now seems to be doing better (at least, if you watch CNBC's Kudlow and Cramer) the Fed, I think, realizes a couple things. The first one should be the most obvious; the burst of activity these last few quarters would not have happened without the unprecedented stimulus the Fed applied. It knows that-even if it does manage to stay on hold somehow-the economy will be slowing more markedly by year's end as the "drug" wears off. Even the first quarter growth number was telling; were it not for the biggest presence of government spending in a year, the 4.2% growth rate preliminarily reported for the first quarter would have been more like 2%.
Second-though it did not specifically cite this on May 4-I guarantee you that the Fed is nervous still about rising energy prices. Until oil prices moderate (IF they ever do any time soon) the Fed will try to avoid raising rates. As Greenspan has intimated on numerous other occasions, higher gas, heating and related energy costs are every bit as much a "tightening" as if the Fed raises the cost of credit.
Let's go a little further. A "number three," if you will, concerns the dollar. Make no mistake: the Fed does NOT want the dollar's recent rally to turn into a new bull market. All things being equal, an aggressive tightening posture would cause the greenback to run; something that is not welcome. For the Fed to keep the economy at least muddling along-even though higher rates of inflation will need to be tolerated-the dollar must weaken further.
Finally, there's the labor market. Though the F.O.M.C. said it "appears" to them that the employment picture is brightening, it will take much more than the last couple months to move them. In fact-just as much as the payroll numbers-the Fed wants to see consistent progress, too, in wage growth. Only then will Greenspan in particular feel that Americans can handle higher interest rates, because first their incomes-thanks to his engineering inflationary growth for the economy-have started rising at a faster rate.
Though he'll never say this, Greenspan knows he needs to create inflation-and lots of it-to avoid the Japan scenario. Inflation helps people "pay" their debts; including, lest we forget, Uncle Sam himself. A weak dollar-which follows when its main guardian is deemed to be "behind the curve" on inflation-helps, too. Both can help keep asset bubbles reasonably levitated. They can also keep the economy at least muddling along.
We saw all of this in the 1970's. As I have said for a while now, Greenspan has been creating for us a "70's-lite" version of things. It won't be long before you hear the word "stagflation" mentioned regularly on television again; even on the nightly network news, rather than just on business television.
This is the road the Fed chairman has taken us down. The alternative-a Japan scenario-is unthinkable.
Greenspan hopes-and possibly expects-that the numbers will soon vindicate him, showing that things aren't "overheating" as some insist. That would certainly take some of the pressure off to raise rates sooner or faster than he wants. Any number of monkey wrenches could be tossed into Greenspan's plans to bring inflationary growth about; in the next issue or two, we'll take closer looks at some of them. The markets could trash his plans tomorrow; then again, he could keep us muddling through almost indefinitely.
In the end, he will be lucky to end up with the same fate as a couple of his predecessors: Arthur Burns and G. William Miller. Burns served as Fed chairman from 1970 until his death in 1978. First appointed by President Nixon, Burns was handicapped early on in trying to run a sound monetary policy when Nixon closed the "gold window" and turned the dollar into a true fiat currency. Following that, the dollar plunged, commodities (and inflation) soared, and Burns could do little more than try to keep things from getting completely out of hand. Miller succeeded him, but could (or would) do nothing himself to stop runaway inflation. He lasted a year and a half, at which time President Carter moved him to the Treasury Department.
The Fed chairman most do remember was Miller's replacement; the man who finally snuffed out the inflation presided over by the other two. Paul Volcker. Though he raised interest rates precipitously and caused what at the time was the worst economic slowdown since the Depression, he was later credited with killing off the inflation and helping set the stage for the broad economic and financial market expansion of the 1980s.
The fate for both Messrs. Burns and Miller is that hardly a soul remembers them. As Greenspan clearly doesn't have the stomach-or to be fair, even the latitude-to clean up his own mess as Volcker did for his predecessors, he can only hope that his policy of unleashing the wildest monetary inflation in history doesn't come home to roost until after he's gone. That way, history might conveniently forget "The Maestro" as it has Burns and Miller.
It's better than the alternative.
The preceding was excerpted from the May, 2004 issue of The National Investor
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