Earth to the Fed! Earth to the Fed!

Guest blogger Flint Stevens of Strategis Financial has our article today, and lo, it's on why the Fed is likely to screw this rate thing up. Can't recall where I heard that before... This is long for my blog, but it's worth reading in its entirety.

April 6, 2006

Time to start worrying about the Federal Reserve

The Nasdaq broke out of its long, narrow trading channel this week. But instead of soaring to much higher levels, as often occurs on a breakout, the index laguished just a few points above the old channel. For that, you can probably blame the Federal Reserve. As most of you know, the Fed last week raised interest rates for the 15th straight meeting. And the statement released with the announcement hinted that another hike is likely at the next Fed gathering.

History indicates that Fed officials are likely to continue raising interest rates until the economy is driven to the brink of recession or is actually pushed over the edge. There is no reason to believe this time will be different. Wall Street knows this, so even though everyone expected last week's addition to the interest rate, it still had a dampening effect on the market.

I'm going to try to explain why the Federal Reserve continually pushes the country into recession, but first I want you to know that most of the information I'm going to provide is readily available at the Federal Reserve's own web site. In fact, on the site you'll find the statement released by the Fed at each Federal Open Market Committee meeting (the gathering where interest rates are set). You'll also find copies of virtually every report the Federal Reserve issues, such as the periodic Beige Book reports. Here is a link to the site and to the site for the St. Louis Federal Reserve Bank:

http://www.federalreserve.gov

http://www.stls.frb.org/default.html

Bill Poole is president of the Federal Reserve Bank of St. Louis. Last week he spoke about the role of federal reserve banks to a gathering of students at the University of Dayton. Here are some of his comments (I've bolded some of the highlights):

"Monetary policy is the most visible of the Fed’s responsibilities. As the nation’s central bank, the Federal Reserve regulates the creation of money and of liquidity more generally. The Federal Open Market Committee (FOMC) is the Fed’s monetary-policy body; it consists of the seven members of the Board of Governors and the 12 Reserve bank presidents, five of whom are voting members at any given time.

"The Fed implements its monetary policy by setting a target federal funds interest rate. The primary goal of policy is to maintain an inflation rate that is low and stable—price stability. Price stability in turn creates an economic environment that fosters maximum sustainable economic growth and sustained high employment. In an environment of price stability, the Fed can respond flexibly to economic disturbances—an excellent example is 9/11—that might otherwise lead to recession. Not all recessions can be avoided, but price stability does seem to have contributed to a more stable economy over the past decade or so."

In other words, the main goal of the Fed is to keep inflation in check. It does this by raising and lowering interest rates and by tightening and loosening the money supply. What I'm more concerned about is how Fed officials determine whether or not inflation is a legitimate concern. Poole again shed some light on that process:

"As for the FOMC meetings themselves, the mystique created by the media is a tad overblown. The responsibility is great, the surroundings are intimidating—we meet in a 56-foot-long boardroom with a half-ton chandelier hanging over our heads. The brainpower assembled in the room is impressive. But, other than the real-time anecdotal information we’ve collected, we have very little information that anyone else couldn’t gather.

"...We aren’t all on the same page all the time. We debate. We discuss the data. We listen to one another’s anecdotes about how the economy is doing. We even chuckle over amusing quips. Then, after reviewing expert staff analysis and all the information and wisdom we can muster, we reach a consensus monetary policy decision. The Fed chairman, of course, leads the discussion and defines the consensus, but when any of us believes sufficiently strongly that another policy course would be better, we enter a dissent."

These comments are a little disconcerting. I guess I always hoped Fed officials had access to better information than what was publically available.

Transcripts of the FOMC meetings are kept secret for five years, then released to the public. You can view these documents online and get a revealing look into what occurs during these meetings. I'm now going to refer to some information contained in the transcript of the May 16, 2000 FOMC meeting.

Think back to the economic situation in May 2000. In February 2000 the Nasdaq peaked above 5,000. By mid-May, the index had dropped to 3,500--a 30% decline. The air was quickly being depleted from the technology bubble and there were other signs that the economy would soon be struggling. Many of these were outlined during that FOMC meeting by Michael Prell, a long-time economic forecaster and analyst for the Fed. Here are some of his comments:

"In the current cycle, there would seem to be a risk of a particularly large decline in the market, given that, by many conventional metrics, we've experienced a speculative bubble of extraordinary proportions. ...But, even if you vastly increase the dimension of the decline, our economic model would still say you can avoid recession, if you cushion the effects by backing off on your tightening."

Pell made other comments about the fact that the Fed had traditionally done a poor job of staving off recession. "...When we've attempted to apply the brakes in the past, we generally ended up skidding into the ditch."

In addition, he said:

"I'd be remiss if I did not mention one other likely reason that soft landings have proven elusive. That is that, in part because of the lags in the effects of interest rate increases and our foggy crystal balls, we probably have a tendency to tighten too much or too long. This undoubtedly would be an argument of those who would caution against more aggressive tightening action right now, with the effects of your first five policy actions still in the pipeline."

So when I say that the Fed historically ends up hurting the economy by raising rates too fast and too long, I am merely agreeing with members of the FOMC, who recognize that tendency. These experts also agree that it takes about nine months before the full impact of the rate increases can be measured in the economy.

At the end of the May 16, 2000 FOMC meeting, Alan Greenspan recommended raising the Fed Funds rate by half a percent to 6.5%. And the sixth straight increase was approved. Nine months later the economy was on the brink of recession, unemployment was soaring, and trillions of dollars had disappeared from the stock market. The Fed had already began slashing interest rates with an unusual pre-meeting rate cut in an attempt to undo the damage it helped unleash. In other words, contrary to Mr. Poole's statement above, the Fed had already weakened the economy so much prior to 9-11 that when the terrorist attacks occurred, it became impossible to prevent a much deeper recession.

Now here we are after 15 rate hikes with the Nasdaq and the S&P 500 still well below their levels of May 2000. The Dow is at about the same mark as it was then. Oil prices remain at record levels--far above 2000 prices. Many experts argue that there is currently a housing bubble. The war against terrorism drags on and the man responsible for starting it still hasn't been caught.

Is the Fed going to pause here, or will FOMC members follow the historical pattern of pushing too far?

Here is the opinion of John Mauldin, an expert economic analyst and best selling author. This is taken from his weekly Frontline newsletter. It is free and you can subscribe at: http://www.frontlinethoughts.com/subscribe.asp

"Much of conventional wisdom suggests that the Fed is at the point of 'one and done.' (Haven't we heard this song before?) Just one more rate increase, thank you very much. I am not buying it. I have said since the Fed started hiking two years ago that they would go further and longer than anyone at the time thought likely. I still think that today. ...

"I believe that interest rates are going higher than 5%. The Fed will keep raising them as long as the economy is growing more than 3% a year, and that could be at least through the summer. That would take us to 5.5%, which is still below the historical mean. There are meetings in May, June, and August, thus the potential for three more hikes. The Fed will only stop raising rates when it is clear the economy, the drive for increased leverage, and the housing market have all slowed. And not a meeting before that."

In coming weeks there will be a deluge of corporate earnings reports from the first quarter. In general, these are expected to be quite favorable. This creates a juncture where the interests of Wall Street, corporate America and the Federal Reserve collide. Rising profits should translate into higher stock prices and business expansion. But businesses don't want to spend money on growth if interest rates are going to rise. So Wall Street and corporate America will hold back, waiting to see what action the Fed will take. The Fed sees the strong corporate earnings, worries about an overheated economy and raises rates again. Can you see how the cycle perpetuates?

There is another complicating factor this time. Last week's FOMC meeting was the first for new Chairman Ben S. Bernanke. As the new guy, the safest course for him to follow is the one began by his predecessor, Alan Greenspan. This was hinted at in the statement released at the latest meeting. "The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance." In other words, the committee stated that it plans to keep raising rates.

It is this last comment that causes the most concern to Wall Street. Traders were hoping that the first statement from the new Fed chairman would provide some indication that the FOMC was finished or nearly finished raising interest rates. Those hopes were dashed at about the same time as the Nasdaq reached a new multi-year high. The effect was similar to pouring water on a fire that was just starting to build.

Ironically, while Fed officials keep hiking interest rates and supposedly working to keep inflation under control, they continue to grow the money supply. That is an act that seems to be in direct contradiction to what they hope to achieve. By pumping up the supply of currency, the Fed provides the fuel for the inflation it claims to be fighting. Since January of 2005 the daily money supply has steadily risen from $6,400 billion to almost $6,800 billion in March 2006.

I must humbly admit that I do not have an economics or finance degree from an Ivy League school. I truly doubt I could match IQs with any of the people who attend the FOMC meetings where the nation's monetary policy is set. But I am smart enough to be concerned when I read comments from those folks like, "...When we've attempted to apply the brakes in the past, we generally ended up skidding into the ditch."

I hope they've since learned their lesson and this time will avoid taking things too far. But I'm not confident that is the case and apparently, neither is Wall Street.

--Flint Stephens