Jubak's Journal 5 reasons the Fed will fumble in 2006 Even with a new chief at the helm, the Fed is heading toward a policy blunder that will inflict a lot of pain on investors. Here are five big reasons why.
By Jim Jubak The odds are now better than 60/40 that the Federal Reserve will overshoot in 2006. It now looks, to me at least, like new Fed chairman Ben Bernanke will finish the inflation battle that Alan Greenspan started by raising interest rates so high that the economy starts to stall sometime next year. The Fed will then be forced to reverse course and start to cut short-term interest rates at the same measured pace that it used to raise them from the June 2004 low. Here are the five reasons I believe the Federal Reserve will give investors a painful demonstration of its all-too-human fallibility in 2006. • The Federal Reserve is fighting the wrong kind of inflation. The classic monetary remedy for inflation is higher interest rates -- that slows the economy, reducing demand. That, in turn, breaks the spiral of higher wages leading to higher prices leading to higher wages, etc. But the current problem isn't classic wage-price inflation. Wages are going nowhere fast; something else is driving inflation. Take a look at the numbers for the quarter completed in September. The economy, as measured by gross domestic product, grew at a 3.8% rate in the quarter. Consumer prices, measured by the Consumer Price Index, climbed at an annual rate of 4.7%, the highest rate of increase since June 1991. Where did that inflation come from? Certainly not from wage increases. According to the Bureau of Labor Statistics, employers' wage costs grew just 2.3% in the last 12 months. That's the slowest growth rate on record, beating out the 2.4% annualized growth rate in wages reported in August. Instead, current inflation is almost all a result of higher energy prices. While inflation including energy is 4.7%; inflation excluding energy is just 1.3%, the lowest quarterly annual rate in two years. (For those readers who think the CPI is so statistically corrupt to be useless -- a valid belief, in my opinion -- the Personal Consumption Expenditures Index, Alan Greenspan's preferred inflation measure, gives much the same result: a general annualized increase of 3.9% in September and a core increase without energy of 1.2%.) This wouldn't matter except . . . • Higher energy prices -- like higher interest rates -- slow the economy. So, in effect, the Fed by raising interest rates is stepping on the economy's brakes at the same time higher energy prices are working to lower economic growth. You can see the effect in a drop in consumer spending in September. Adjusted for inflation, consumer spending dropped 0.4% in September, following a similar drop in August. And it's not hard to understand why: With energy prices up and wages down, consumers are digging deeper into already empty pockets to keep spending. In the September quarter, that led to a negative rate of personal savings in the U.S. (savings fell at a 1.1% annualized rate). There are certainly big problems with the way that this number counts savings, so it's just about certain that the real savings rate isn't negative. But savings rates are dropping, and we're already in historically low territory: The personal savings rate hasn't been negative since the Bureau of Economic Analysis began keeping quarterly savings numbers in 1947. At a time when consumers can keep spending levels up only by borrowing (whether on credit cards or by refinancing a home or taking out a home-equity loan), higher interest rates from the Fed are Strike 2 against the economy. And the currency markets are set to deliver Strike 3. . . • Higher interest rates have produced a rally in the U.S. dollar, which makes U.S. exports less competitive in global markets and puts even more downward pressure on U.S. economic growth. I know it's perverse: The U.S. is running enormous trade deficits that leave us dependent on the savings of strangers; no one in Washington gives a second thought to spending billions we don't have; and companies in core U.S. industries such as autos and airlines are flocking into bankruptcy. But the U.S. dollar has rallied against most global currencies. This week the dollar hit a 25-month high against the Japanese yen, after gaining 14% in 2005 against the yen. The dollar is even up 12% this year against the euro, after falling by almost 50% against the European currency from 2002 to 2004. A higher dollar makes U.S. exports more expensive for foreign consumers. U.S. companies can combat that by outsourcing more production to cheaper, non-dollar international economies, and by firing U.S. workers and hiring workers in those same cheaper non-dollar economies. But those adjustments produce lower incomes in the U.S. and cut into U.S. economic growth. The Fed's policy of hiking U.S. interest rates has contributed to this drag on growth, as well, since higher U.S. rates have propped up the U.S. dollar against other currencies. So why is the Fed pushing up interest rates further when it could be so harmful to the economy? • When all you've got is a hammer, all problems look like nails. Raising interest rates may be the worst available tool for fighting inflation caused by higher energy prices. But what other tools are available? The other players in Washington show no inclination to break out their economic policy tools -- and it's even questionable that they know where they are after years of budget-busting neglect. Congress and the president could fight higher energy prices by doing something to damp energy demand (an energy conservation policy that consists of more than a presidential exhortation to drive less would be a start). Or to increase energy supplies (although I'm not sure that throwing money at Archer Daniels Midland and the rest of the ethanol lobby is a worthy goal in and of itself.) But not even the members of Congress believe that the recent energy bill will do anything significant to reduce demand or increase supply. So that leaves the Federal Reserve to do the job of reducing demand by whopping the economy over the head with its higher-interest-rates hammer. • And, finally, circumstances have conspired against the Federal Reserve to increase the likelihood of a policy mistake. Hurricanes Katrina, Rita and Wilma have tied statisticians in knots and made it extremely difficult to figure out the underlying trends in the economy. For example, the Bureau of Economic Analysis reported a healthy 0.76 rise in inflation-adjusted personal income in September. (Personal income, which includes not just wages but rental and investment income, isn't the same as wages.) But, adjusted for the hurricanes, personal income may be higher, lower or the same as in August. For example, in the earlier month property owners in the disaster area took a big hit to rental income, which depressed August's numbers and made it easier for September to show a gain. The Economic Policy Institute calculates that absent the hurricane bounce-back effect, personal income fell 0.43% in August. And the transition from Greenspan to Bernanke encourages the central bank to continue current policy until after the March meeting of the Federal Open Market Committee. Reversing course when Greenspan is barely out the door isn't a reassuring way to begin the Bernanke years. A slowdown, yes; a recession, no I think the result of all this is that sometime in 2006 -- around midyear would be my guess given the lag before an economic trend starts to show up in the economic numbers -- the Fed will be facing a big growth surprise. Inflation may or may not be under control, but growth will have dipped toward the low end of the range that makes the Fed comfortable. And it's likely that there will be signs that growth could be headed lower. Note I'm talking about a drop below the current 3.8% growth to a rate that makes the Fed, Wall Street and Washington politicians (who are facing midterm elections in November 2006) nervous. I'm not talking about a negative quarter and certainly not a recession. A drop below 3% is a certainty if the Fed's interest rate policy overshoots. And somewhere in the range of 1% to 2% growth for a quarter would be a reasonable expectation for a low. By the time that growth low arrives, the Fed will have stopped cutting rates and is likely to begin sending signals of an ease or two if the growth picture doesn't improve. To me, this doesn't add up to either economic or investing disaster. More volatility than we've seen even in the last few months? Certainly. Radical shifts of money between sectors as the managers of hot money search for short-term profits? Certainly. Enough worry about rates of interest and growth to cause a flight to safety in assets that range from gold to consumer staples? Certainly. Looking out over the next six to 12 months, I think shifting portfolios to include more non-U.S. equities makes sense. In the near term, a stronger dollar will increase the sales of overseas companies. In the longer term, a decline in the dollar as the Federal Reserve stops raising interest rates will give investors in non-dollar-denominated assets a decent exchange-rate profit. I also think looking to U.S. consumer companies that represent safety from inflation and strong guarantees of growth is a solid strategy. … - Jim Devine "Segui il tuo corso, e lascia dir le genti." (Go your own way and let people talk.) -- Karl, paraphrasing Dante.
