In January, I suggested that 2005 would be the year of the See-saw Economy. So far, with one major exception, my forecast is in the middle of the fairway. See-saws work as long as both partners work together. Indeed, with proper co-operation, they are quite fun. But there will always be some who lets their partners get to the top of the ride and then jump off, allowing them to drop to the ground.
Now the world’s economic see-saw is precariously balanced between a U.S. trade deficit and foreign central bank buying of U.S. treasuries. ‘I think the game continues though 2005. It is in no one’s best interest to stop the game,’ I wrote in January.
Here we are in July, and the Fed still has the same problem it had in January, only we are six months closer to the end of this tightening phase. It almost certainly is going to tighten another 25 basis points at the August meeting. The question at that point becomes whether or not they will change the language in the release. Will we lose the word ‘measured’?
I think we need to acknowledge that the bias among Fed members is to continue tightening. But it may be time for them to change their tuneThere are some arguments that can be made for raising rates. Clearly, the low rate environment has fostered a significant rise in the price of homes, if not a housing bubble in certain areas. The Fed, as it should be, is concerned about adding fuel to the flames. Allowing a real housing bubble to develop because of an overly stimulative Fed policy would create real problems when it burst. Significantly falling housing prices in the U.S. is a problem that the Fed has few, if any, tools to deal with.
When housing bubbles burst, they are generally accompanied by foreclosures, and thus oversupply on the housing market. Because of the large number of houses that are being bought for investment purposes with little or no money down, a cycle of foreclosure would be difficult to stop with interest-rate cuts alone.
I continue to refer to a speech that Greenspan gave two years ago. He said the Fed should set its policy so as to insure that significant damage is not done to the economy. Rather than try to micro-manage every little part of the economy, it was better to worry about the biggest risks that would cause the most damage and use policy to avoid those risks. ‘First, do no harm,’ he said.
Continuing to raise interest rates at a measured pace in the hopes of slowing the rise in home values and letting a little of the air out of the bubble certainly has to be in the mind of every Fed Governor.
Further, the economy is in relatively good shape. Headline unemployment is down to 5%. The U.S. government deficit is coming down as tax receipts are way, way up. (Now if Congress could only show a little discipline and stop spending!) Corporate profits, both as a percentage of GDP and on an absolute basis, are at an all-time high.
Corporations have significant cash reserves. The stockmarket, while not exactly in a bull run, is doing fine. Price-to-earnings ratios can come down in several ways. Either the price of the stock drops, or the prices stay flat and earnings increase. We’ve seen the latter for several years. This is a much better way to get to low valuations than a recession.
But if the principle is ‘first, do no harm,’ then you could also make a strong case that the Fed should stop raising rates after the August meeting. First, it is not altogether clear that raising short-term rates will have any real effect on long-term rates, and thus on mortgage rates. It certainly hasn’t had much of an effect so far. As I noted in last January, I don’t think the Fed wants to create an inverted yield curve by purposely raising short-term rates above the 10-year note.
And there are questions about the real strength of the economy. Unemployment may not be as good as it sounds. The current low U.S. unemployment rate probably understates the true level of joblessness by one to three percentage points, says Katharine Bradbury, the senior economist at the Boston Federal Reserve. Millions of potential workers who dropped out of the labor force during the recession four years ago have not returned as expected, and are thus not counted in the official unemployment statistics. (https://www.bos.frb.org/economic/ppb/2005/ppb052.pdf)
Inflation is low, which is a good thing, unless you have a recession. Core inflation is below 2%. If you look at the personal consumption price index, core inflation is only 1.5% and that is the index the Fed generally prefers to look at. There are many observers who think the economy will soften in the latter half of this year. I agree.
Softness is not a recession, but raising rates while the economy is in the process of softening can help bring about a recession. And a recession today (or an economy only growing 1-2%) with inflation so low would almost certainly bring back the deflationary scares of 2002. The 10-year note could drop to 3% and mortgages would go to 4%. What such a scenario would mean is open to debate, because I can argue at least three scenarios forcefully, and another two or three that might be of interest. It would create a lot of uncertainty and markets hate uncertainty.
Oil and energy prices are beginning to have an effect upon consumer spending and are certainly a drag on growth. On one side of the see-saw is the potential for the housing market to do well and truly overheat. On the other side is the potential to tighten too much in the face of a softening economy and maybe push the economy into recession. That would also not be good for housing and would certainly bring us closer than we would like to outright recession.
I think the prudent thing to do would be for the Fed to signal that they are going to pause in their rate hike drive for a meeting or two, while they keep a sharp eye on the economy to make sure things don’t get too hot. They don’t want to signal that all chances of more rate hikes are over, as that would create a new set of problems, and neither do they want to suggest that they are concerned about economic growth. The press release after the next board meeting in August may be the most important we have read in many years.
By John MauldiJohn Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. To subscribe to John Mauldin’s E-Letter please click here