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July 3, 2006

Fed Watching - Just Say No

John P. Hussman, Ph.D.
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Economics Pop Quiz

1)  Since 1965, increases in the Federal Funds rate over a 12-month period have been associated, on average, with:

a) lower and slowing inflation over the following year

b) higher and accelerating inflation over the following year

2) What is the relationship between the growth rate of the money supply and the rate of inflation over the following year?

a) clearly positive

b) roughly zero

3) How is faster economic growth related to the rate of inflation?

a) faster economic growth is associated with higher current inflation and also higher inflation over the following year

b) faster economic growth is associated with slower current inflation and has roughly zero relationship with the rate of inflation over the following year

4) Which indicators are more useful in anticipating subsequent levels and changes in the rate of inflation?

a) GDP growth, money supply growth, the Federal Funds rate and the unemployment rate

b) Government spending and its share of GDP, growth in hourly wages in excess of productivity growth, and changes in market interest rates.

If you answered b to all of the above, you're absolutely correct. As Will Rogers once said, “It's not what people don't know that hurts them. It's what they do know that just ain't so.”

The financial markets continue to have what I view as an unhealthy and pointless obsession with the Federal Reserve. Unhealthy because it detracts attention from the significant risks posed to the stock market from rich valuations, and to the economy from an enormous current account deficit, weakening housing, and flattening employment conditions. Pointless because the monetary policy is now, and always has been, the gopher of fiscal policy. The Fed can do nothing but decide whether government liabilities held by the public take the form of money (currency and reserves) or Treasury securities. It has no power to determine the total quantity of those liabilities (Congress does that). Whatever influence the Fed ever did have was largely removed in the early 1990's (see Why the Fed is Irrelevant).

The overriding debate in the financial markets is what the Fed will do next, because a) investors see the Fed as having a choice as to whether or not to raise rates and b) they think it matters. Over the coming year or so, the real surprise may be that a) the Fed doesn't have a choice, and b) it doesn't matter anyway.

Part of the problem here is that the markets and even the Fed seem to be looking at current inflation rates as a cyclical issue rather than a structural one. The model in people's heads is that the recent rate hikes will “cool the economy down” and thereby “ease pricing pressures,” leading to a Fed engineered “soft landing.” Except if the Fed "overshoots," which will lead to the dreaded “hard landing.”

Hogwash.

Pure, unadulterated hogwash. Asking whether the Fed ought to raise rates by another quarter-point to avoid inflation is like asking Christopher Columbus what sort of trees he thinks are planted at the edge of the Earth. The question assumes a model of the world that's just plain wrong.

The proper model that ought to be in people's heads is that, yes, the economy will probably slow down, but largely because it's living on a mountain of debt that's going to have a hard time growing because of a) stalling home values and b) a massive current account deficit that's unlikely to expand indefinitely. So sure, the economy will probably continue to slow. If that happens, we can expect to observe higher, not lower, rates of inflation unless credit defaults increase enough to lower monetary velocity and counter the otherwise detrimental upward pressure that slower economic growth generally has on inflation.

Among the factors that actually have a good record in explaining levels and changes in subsequent inflation, fiscal policy remains in disarray, and is likely to provide no help containing inflation in the near future. This is a structural problem, not one that's going to go away if the Fed hikes rates another quarter-point. On the matter of interest rates, the notion that higher rates will reduce inflation pressure is also counterfactual. It's just not in the data, and in order to make it show up in the data, you need to restrict the analysis to points where bank liquidity was already tight (it's easy, for example, for the Fed to trigger deflation during a bank run).

One of the first things economists teach their students is the idea of "declining marginal utility." You might enjoy the first ice cream cone a great deal, but the next one has a slightly lower utility to you, and the third one has even less. So as you have more stuff, the value of an extra unit of stuff goes down. Inflation basically occurs when the marginal utility of goods rises relative to the marginal utility of government liabilities (because, for example, goods are in short supply, or government liabilities become relatively plentiful, or both).

The fact is, rising and accelerating interest rates are generally followed by higher subsequent inflation rates. This happens because rising interest rates are a signal that the marginal value of government liabilities is declining, and securities prices adjust faster and are more forward looking than goods prices. And, also because securites prices are forward looking, significant reductions in inflation typically begin only after inflation has increased beyond the level of interest rates, first producing low or negative real interest rates, and later, falling inflation. Negative real interest rates are a far better predictor of declines in inflation than rising Fed Funds rates are.

If anything, interest rates are currently indicating a likelihood of higher, not lower inflation here. Also, we've probably only begun to observe wage increases in excess of productivity growth, which tends to spill over to general price inflation as well. I've noted the likelihood of wage increases in the context of the very high share of revenues and GDP currently going to corporate profits. This again is not a cyclical problem that will just go away if GDP slows a bit.

The upshot is that barring credit problems and a move to negative real interest rates, investors should allow for the possibility that inflation pressures will be structural and persistent here, not cyclical (in the sense of moving in the same direction as economic growth). It will certainly be important to monitor credit spreads and the like, because weakening credit conditions would carry very large sway on inflation rates. But in any case, it's important to get the model right. The Fed is simply not that important here.

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment position. The recent “fast, furious, prone to failure” bounce has now fully cleared the prior oversold condition of the market. It's that “prone to failure” bit that's relevant here. The usual positive but minor seasonal factors (last couple of days of the month, 2 days pre-holiday, and first few days of a new month) suggest that we should at least allow for some amount of additional recovery, but in unfavorable Market Climates, the risks can become fairly large once the market has completed a clearing rally.

In bonds, the Market Climate was characterized last week by roughly neutral valuations and roughly neutral market action. We don't yet observe widening credit spreads or other factors that would suggest falling inflation pressures (as noted above, I think it's a mistake to believe that slower economic growth alone implies this). As a result, we're still holding a relatively limited duration of just over 2 years in the Strategic Total Return Fund, mostly in Treasury inflation protected securities, as well as a roughly 15% position in precious metals shares.

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