When Will the Fed Stop?

John Mauldin | Thoughts from the Frontline
March 31, 2006

This week the US Federal Reserve raised interest rates once again, for the 15th straight time. As everyone knows by now, the press release at the end of the meeting suggests that they will raise rates at the next meeting. But after that? Like children in the back seat of the car on a long trip, the markets keep asking "Are we there yet?" We look at that answer and more as we ponder what goes on in a central banker's mind.

First, let's look at the actual FOMC statement. I think, given the background we will discuss in this week's letter, there are nuances that we can find which will give us a few clues as to future Fed policy. I step out on a limb here, or maybe it is better to stay I remain far out on the limb where I perched myself two years ago. It should make for an interesting letter.

When the Fed statement is released, I typically get a copy within a short time and read it to see if anything is really new or different. Then I put it aside, knowing that early the next morning, Art Cashin, head floor trader for UBS and de facto sheriff at the NYSE (you see him on CNBC every day on Ron Insana's show) will send me a word by word analysis of the Fed statement as compared to the most recent past statement.

Here's a free marketing tip for the powers that be at UBS. Art writes one of the more entertaining, useful, and addictive daily commentaries on the markets anywhere; and I can't for the life of me see why your compliance types at UBS wouldn't consider it something that should be made available for general public consumption. Stick a bunch of disclaimers and legal language in it, throw in an ad for some UBS service (hey, they got to make a living), and then the rest of the world gets the benefit of Art's commentary and wisdom. It would soon be one of the more popular letters on the internet. (In Art's defense, he most definitely did NOT put me up to this. Just me trying to be helpful.) Anyway, to the Fed statement.

The Potential for Inflation Pressures

This was the first meeting with Bernanke as Chairman. Bernanke has been known to advocate for a more transparent Federal Reserve policy. Would he use this first meeting to establish such a direction? There were also two new members, so there was some speculation that we could see something more than subtle differences. As things turned out, we didn't. As Art noted:

"Both the March and January statements were five paragraphs long. Paragraphs 1, 4 and 5 were basically identical. Even paragraph three, the policy paragraph was virtually unchanged. Here is paragraph three from both the January and yesterday's statement:

'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 any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.'

"...So let's look at paragraph two which describes the FOMC's view of the state of the economy. Here's what they said back in January:

'Although recent economic data have been uneven, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.'

"And here's how they described the economy yesterday:

'The slowing of the growth of real GDP in the fourth quarter of 2005 seems largely to have reflected temporary or special factors. Economic growth has rebounded strongly in the current quarter but appears likely to moderate to a more sustainable pace. As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained. Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.'"

So, what was the real difference? The Fed tells us what we already know. The economy seems to be heating up again quite nicely. One-time factors (Katrina?) were responsible for the slowing in the fourth quarter, but now that is behind us. But they keep the portion that says ...energy and commodity prices "have the potential to add to inflationary pressures."

So, central bankers the world over walk into the office this morning and review the situation. Gold, which historically has been an inflation hedge, is at $588, within shouting distance of $600. What does gold see that the CPI doesn't? Every time it looks like it might correct into its normal after-holiday slump, it fails to do so. Bond yields are beginning (finally!) to rise. Employment is looking better. Productivity is high and rising. Housing sales are slowing but prices have yet to really moderate, other than for some anecdotal evidence here and there.

Commodities across the board are making new highs. Copper and the major metals are soaring, silver is at $11.66 (is it real or is it the new silver ETF?) and oil -- will oil ever drop into the $40s again?

Rising commodity and energy (input) prices, rising employment, rising capacity utilization, rising gold, and a growing world economy. These are certainly the conditions for the "potential to add to inflationary pressures."

So the Fed funds rate is going to 5% in May. That is pretty much a given, barring a highly unlikely collapse in the US economy in the next month. Given that we were at 1% just two years ago, 5% seems rather high. But from an historical basis, it is not.

Good friend Barry Ritholtz (and now a regular on Kudlow) provides us with this graph:

From 1946 through 2000, the median Fed funds rate was over 6%. That means half the time it was over 6%. When they ended the last tightening cycle (long enough ago to seem like the Jurassic Age), the rate was at 6.75%. The US economy grew rapidly from 1946, with short-term rates above 6%.

Given that historical perspective, and given that the Fed sees "potential to add to inflationary pressures," it is hard to see how they will not seriously entertain raising rates beyond 5%.

Velocity Versus Money Supply

Central banks around the world are draining liquidity from the system as fast as they can. Those very smart people from GaveKal track global liquidity. As you can see from the chart below, it is falling and has been for what looks like 18 months.

Note that extended periods of contracting liquidity have often resulted in a slowing economy. But banks, consumers, businesses and hedge funds are not cooperating. They are busy adding to liquidity as fast as they can leverage up. This can be seen through the velocity of money; i.e., how fast money is going through the system. Velocity is the number of times a dollar is spent, or turns over, in a specific period of time. Velocity affects the amount of economic activity generated by a given money supply.

Below is a graph of the velocity of money from the St. Louis Fed: http://research.stlouisfed.org/publications/mt/page12.pdf. Velocity has gone down throughout the '90s and on into the late recession. But since that time, it has started to rise. As an aside, this is one of the reasons Greenspan could really grow the money supply without seeing a return of inflation. We simply were not using the dollars as "rapidly" as in the past. But now, that trend has changed.

Which brings us back to another graph from GaveKal. This one tells an even more interesting tale. They chart the difference between liquidity and velocity. Quoting from a recent paper to their clients [my comments in brackets]: "...the central banks pile on the brakes [taking away liquidity] while the private sector is happy piling on the leverage [borrowing for business investment and consumption and the carry trade, which is borrowing in a currency with cheap interest rates to invest in places with higher returns]. But can such a situation last for long? To be honest, we started getting very worried about the divergence between our M [global liquidity above] and our V [velocity] indicators at the end of the summer. But since then the divergence has continued to grow."

This divergence is at its most extreme for the last 13 years. Further, increased velocity is often associated with an increase in "inflation pressures." That cannot escape the notice of a central banker.

Why the increase in leverage? Because of the great irony that people - business, investors, and consumers - see less risk in today's world. They are more comfortable, therefore, in taking on even more risk. And in an era of perceived lower risk we have seen returns in almost all asset classes fall. But periods of lower risk premiums do not usually end up neatly.

As Bill Gross noted this week: "When one can buy a U.S. agency guaranteed FNMA mortgage at a higher yield than almost all emerging market debt, then there exists an irrational pricing of credit. In general, almost all risk and associated "premia" are now trading at illogically low levels and as Alan Greenspan warned just months ago, history has not dealt kindly with the aftermath of protracted periods of low risk premiums. 'Periods of relative stability' in fact, 'often engender unrealistic expectations of permanence and at times lead to financial excess and economic stress,' he said."

Thus, we are getting toward the end of a cycle which has been played out numerous times, as GaveKal and others (including your humble analyst) have noted. First, there is a downward shift in the risk return curve. Thus, as investors are getting lower returns they also get less volatility. So, in an effort to increase yield they move up the volatility curve. They can do this two ways; either move into more risky investments (i.e., emerging market bonds, stocks, commodities, etc.) or employ increased leverage. When rates are low enough and there is lower volatility, then why not do both? It seems so easy.

Thus, as leverage increases, central banks get nervous and put on the brakes. They begin to raise rates. And let me note, this is a battle that central bankers will win. They can slow down the train if they decide to.

With Higher Leverage, Cost of Capital Rises Above Returns

"As the desire to leverage increases, the demand for capital accelerates. With the higher demand for capital, its price usually goes up. At the same time, central banks start to lean against the increase in leverage, hereby further increasing the cost of capital. At some point, the rising cost of capital meets up with the falling returns on invested capital.

And that precipitates a financial panic. The momentum and carry trade investors get "taken out" and the "return to the mean" investors thrive. At this stage, one wants to own nothing but cash, and government bonds." (GaveKal)

This increased cost comes in several forms. Adjustable-rate mortgages are a form of leverage. As rates increase, so do the costs of the leverage. Credit cards are a form of leverage. Businesses see their cost of capital increase. Certain types of hedge funds are seeing their investment styles squeezed because of increased interest-rates costs. Of course, there are some hedge funds that benefit from increased rates, especially trend-following futures funds who have most (up to 90%) of their actual funds in cash. 5% interest rates make a fund look 4% a year more profitable. (As an aside, that is why certain types of funds should always be additionally compared to a cash benchmark over time.)

A Peek Behind the Curtain

So, how far will the Fed raise rates? What is their magical formula? Alas, there is no all-seeing formula. Today, Art sent me this note which seems to fit well within this week's theme:

"A Peek Behind The Curtain - St. Louis Fed President William Poole spoke at the University of Dayton yesterday. His speech was a bit of a tutorial on the operations of the Fed. It was all interesting and enlightening but we zeroed in on this spot:

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. If you read the minutes of the meetings, and especially if you read the verbatim meeting transcript that is released with a five-year lag, you will see 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. And when the FOMC meeting is over, we adjourn and have a lunch of soup, cold cuts and salads, just as we are about to do today.

Just folks. No robes and secret rituals. Kind of makes you nervous doesn't it?"

But "just folks" who have been given a special injection of central banker gene therapy when they join the Fed. And that therapy requires them, with a genetic urgency, to fight both inflation when it seems to be the battle du jour and deflation as they did in 2001-2002. And when they are fighting inflation, history shows that they almost always go too far in the tightening phase.

It takes, we are told, about 9 months for the effect of an interest rate hike (or cut) to work its way through the economy. Thus, by the time we see the effect, it is long past the event which may have caused it.

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. There are a few people out on that limb with me, like Dennis Gartman and Barry Ritholtz, but not enough so that the limb is breaking under a crowded load.

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.

For what it's worth, I think they should take a pause this summer and let's see what happens. They can always play catch-up this fall.

Pitching and the Optimism of Youth

Speaking of catching, as long time readers know, my office is in the Ballpark in Arlington where the Texas Rangers play. My office balcony overlooks right field. (Yes, some company called Ameriquest paid gazillions for the naming rights last year, but the citizens of Arlington paid the taxes on the place; and so for me, it will always be the Ballpark.) Right down the hall from me is the offices of the scouting group for the Rangers. One of the young men who works there walked out of the office as I walked by, and I asked him if we were ready for Opening Day, which is next Monday. He said, confidently, "Sure."

"Got some more pitching then?" Texas never has enough pitching. Hitters we get in spades. "Well, actually, we lost our #2 pitcher yesterday for the next three months."

He saw the look on my face. "Don't worry," he said. "We are bringing another pitcher up from the minors to replace him. We are going to do just fine."

I sigh even as I write this. How many beleaguered fans of any sports team sigh at the end of each seasons and say, "Wait till next year." It is a particularly virulent disease among baseball fans. We start the spring season with such hopes. The rookies look like they are going to break out. An old warrior, traded to a new team, seems to have life in him yet. If so-and-so can just step it up a notch. We start looking at schedules in September, to see who we will have to bet in the stretch run.

It infects young and old alike. Rich owners throw money into old arms in the vain attempt to get into the Series just once. It is a delusion, of course, but what a magnificent delusion. Maybe the kid is right. Maybe the rookie from the minors will find some new juice. Maybe the relief squad can keep us in it until the starter comes back. Maybe this is the year that our pitching does not wilt in the Texas heat in August.

And maybe the Fed will stop raising rates before they slow the economy down.

We start with the Boston Red Sox in a sold-out day game. Some of my kids are bringing friends, so it will be good to visit. I actually plan to work on Monday, although I may sneak out onto the balcony and watch a few innings with them. When the Rangers hit a home run, they set off some very loud fireworks. It sounds like a cannon in my office. If I am sitting and working at my computer, which I often am, even after all these years I still jump. But it always brings a smile. Another one for the home team.

Have a great week! And the best of luck to your team! See you in the play-offs!

Your hoping to hear those cannons roar analyst,

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