July 2005
The "conundrum" of falling long-term interest rates when the Federal Reserve is ratcheting up short-term interest rates has confused the likes of Fed Chairman Alan Greenspan but that has not deterred him from continuing to increase rates. Some economists believe the Fed should stop now or risk a recession next year. We think the financial markets agree with the Fed's direction of monetary policy and are confident they will react appropriately to extraordinary events if and when they happen.
On June 30th Alan Greenspan and the Federal Reserve continued along the path that they began a year ago to once again increase short-term interest rates by a quarter of a percentage point. This was the ninth increase in 12 months that brought the federal funds rate (the overnight bank lending rate) to 3.25% from 1.00%. While some economists are recommending that the Fed should stop raising rates now, the central bank has made it clear it has at least one more increase to go and probably more. This has equity investors wondering, "How much is too much?"
As we have mentioned before, this interest rate cycle has been unique from an historical perspective because long-term rates declined as the Federal Reserve was increasing short-term rates. Normally they move in the same direction. There are many theories as to why this happened but the important point is that it has reduced the effectiveness of monetary policy and the central bank's ability to influence the economy.
For example, 30-year mortgage rates are lower today than they were when the Federal Reserve started raising short-term rates a year ago so the Fed's actions have not been as useful in slowing down the real estate market despite concerns about the bubble in housing prices. The additional equity that people have in their homes from rising real estate values has been used for additional expenditures that they might not otherwise have been inclined to make. This "wealth effect" has offset a good portion of the Fed's tighter monetary policy objectives. That is one reason we think they have the ability to raise interest rates higher.
There are other reasons why we think that Mr. Greenspan is confident in the economy's ability to withstand additional measured increases in rates. First of all the economy grew at a respectable real rate of 3.8% in the first quarter and is expected to continue to expand at a 3.0% or higher rate for the rest of the year.
Secondly, employment has risen by an average of 180,000 per month so far this year and those employed have received better increases in wages and salaries over the past year. Again, this is an indication that the economy has self-sustaining forces working within.
These economic statistics help explain the jump in consumer confidence in June to the highest level in three years. According to the Conference Board survey, Americans were more satisfied with their current financial situations than at any time since September 11, 2001. We find that surprising with gasoline prices so high but that implies other factors are more important.
There was recently good news from the manufacturing sector that business is picking up. In addition, despite all of the bad news about companies moving their manufacturing plants overseas, companies have been spending money on new plants in the U.S. at the fastest pace in many years. It is especially true among foreign owned firms that want their production facilities to be closer to their U.S. customers. Maybe we won't just be a country of hamburger flippers after all.
While the Fed is concerned about the rise in inflation over the past year, it is comforted by the fact that inflation expectations have not risen by very much. People have confidence in the Fed's ability to keep inflation under control. Expectations for low future price increases limit the urgency to buy now which helps contain inflationary pressures. It should be kept in mind that inflation expectations lag actual results and will increase over time if the actual rate of inflation goes up. The Fed would like to keep that from happening so they will give rates an extra boost as an ounce of prevention.
Those economists who call for the Fed to cease and desist from increasing short-term interest rates any further believe the economy has a weak foundation. They think it has only been able to grow because of deficit spending (including tax cuts) by the government, a weaker dollar, and a low real interest rate policy by the Fed. The stimulation effects of these policies have been spent and with budget deficits already high and real interest rates already low there are no other ways to stimulate growth going forward. A severe slowdown or recession is the inevitable outcome.
They also point to the severe headwinds of rising oil prices and slowing growth rates in corporate earnings and cash flows required for future investments. Our European trading partners and Japan are still experiencing very little growth and it is feared that China's economy will be moderating too so our exports to these countries will slow.
Despite these challenges, we think the U.S. economy has the ability to sustain a growth rate of about 3.0% over the next two years. This is primarily due to the fact that capital spending on plant and equipment is kicking in at a decent pace and employment continues to grow at a level that can more than absorb new entrants into the job market. Wages and salaries are rising along with the higher employment rates.
We think Chairman Greenspan has proven his skill in setting monetary policy over the past 18 years and we support his actions at this stage of the economic cycle. The financial markets also have demonstrated confidence in the Fed as evidenced by the low long-term interest rates, narrow credit spreads, and a stock market that has held up pretty well in the face of rising short-term rates, slowing growth and the bombing in London.
Assuming the kind of economic growth we described, it is prudent for the Fed to keep raising short-term interest rates to a more neutral level. That would not be too much for the economy to handle, in our opinion.
However, if oil prices should continue to rise or there should be other shocks to the economy like a terrorist attack, we would expect the Fed to react accordingly and provide liquidity as it did following other crises in 1987, 1997, 1998 and 2001.
Because of our expectations for the Federal Reserve to raise short-term interest rates at least two more times, we expect the stock market to remain in a trading range and to continue to react to changes in oil prices. A significant drop in oil prices and/or an indication that the Fed has stopped raising rates could spark a meaningful rally.
In the fixed income market, we continue to focus on the 2-5 year maturities where we can now capture most of the yield that bonds have to offer and limit the risk.
John W. Gudritz, CFA
john@frontstreet.com