View Full Version : End the Rate Increases

10-19-2004, 06:33 AM
An interesting take on current monetary policy. I think it's fair to say that the bond market views inflation risks as declining.

End the Rate Increases

October 19, 2004; Page A18

The U.S. economy is heading for a post-stimulus hangover. The double drag from higher oil prices (a tax increase) and higher short-term interest rates is not helping. If we aren't careful, we'll have a recession in 2005. That possibility makes even more dangerous the tax increases being proposed by John Kerry.

Don't get me wrong. The economy has had plenty of help, at least up until this fall. Two rounds of Bush administration tax cuts added about a percentage point to growth for most of the period since mid-2001. First, by helping to end the brief recession that ran from March to November 2001, and then helping to sustain growth in 2003 and early 2004. The Fed did its part, cutting the federal-funds rate in half from 3.50 to 1.75 during the first two months after the Sept. 11 shock, and then cutting by another 75 basis points during the 2003 deflation scare.

With all of this well-executed stimulus from monetary and fiscal policy, the U.S. economy has averaged 3.5% growth since the end of 2001, even with an extraordinary negative real fed-funds rate averaging -0.5%, the lowest level in a period of falling inflation since the great depression of the 1930s. Achieving only trend growth required tax cuts and a negative real fed-funds rates that generated record low mortgage rates and cash out refinancings worth $100 billion annually. Also, oil prices stayed down until the second half of 2003.

If with all that stimulus and low oil prices, we managed just 3.5% growth, how can we manage the 5% growth the Fed predicted last July as it started raising the federal-funds rate? Indeed, now that the fed-funds rate is up to 1.75%, tax cuts are over, "refis" are down, and oil prices are up $25 a barrel since the second half of 2003, how can we be sure we don't have a recession coming in 2005?

Most models suggest that higher oil prices cut growth with a lag of six months or more, notwithstanding Alan Greenspan's claim to the contrary. We probably haven't yet seen the negative growth impact of the $25-a-barrel rise in oil since the second half of 2003 and that will be, conservatively, at least 1 percentage point off of trend growth. Take away another 1.5 percentage points from the expiration of fiscal stimulus and cash out refinancings and add in some more drag from higher short-term interest rates and you are close to zero growth. A lower stock market tied to earnings disappointments could do more harm. Falling long-term rates are presently a symptom of slowing growth.

Higher oil prices are acting like a tax on households and producers and so are penalizing growth while not raising inflation. That's the message emanating from lower long-term interest rates world-wide. Both aggregate supply and demand curves are shifting leftward. Higher oil prices mean less output at each price level, a negative supply shift. Higher oil prices, lower cash-out refinancings and an end to tax cuts subtract from demand growth. Real consumption was flat in August. While it may rise in September given a dumping of auto inventories, and a late Labor Day, the sharp drop in October consumer confidence to its lowest level since the deflation scare in April 2003 bodes ill for consumption going forward. Meanwhile, inventory growth, begun during the second quarter, has continued, signaling a need for a production slowdown that has begun. Industrial production in the three months ending in September rose at an annual rate of just 2.8%, down sharply from the previous year's 4.7% growth.

Weak demand growth and some inventory buildup have erased last spring's inflation scare when core inflation measures moved toward 2% and were expected to move still higher. Core CPI inflation was only 1% annualized during the three months ending in August, down from a 2.2% rate for the previous six-month period. If the Fed was thinking of a 2.5% inflation rate by year-end when it began tightening in June, it may have thought that a fed-funds rate at that level, yielding a zero real fed-funds rate, would still be accommodative. The minutes of the Fed's August meeting, when the fed-funds rate was raised to 1.5%, suggested this view: "Given the current quite low level of short-term rates, especially when judged against the recent level of inflation, members noted that significant cumulative policy tightening would be needed. . . ."

The drop in inflation to 1% would mean that the real fed-funds rate has already risen to 0.75%, still low, but in the context of the past several years, still possibly too high to support trend growth, especially given the withdrawal of other stimulus coupled with a substantial oil tax.
* * *

Going forward, sustaining growth will require three key steps. Although the leeway for further tax cuts is limited, current tax cuts should be made permanent in order to give households and firms greater confidence about the future tax environment while avoiding additional tax burdens to the substantial drags already hitting the economy from higher energy prices. Beyond that, marginal tax rates should be further reduced with revenue losses recouped by eliminating tax preferences.

Second, the Fed needs to sharply re-examine its concept of the current neutral real fed-funds rate. The evidence of the past several years suggests that the neutral real fed-funds rate for the post-equity-bubble U.S. has been closer to 0% than 2%, so any increases in the fed-funds rate above current levels should be undertaken only after careful examination of an appropriate rate. The rationale sometimes heard, that the Fed needs to raise the fed-funds rate in order to have the leeway to cut it in the future, is essentially silly if such rate increases themselves lead only to the need for future rate cuts.

Finally, whatever the growth environment, the U.S. needs to reassert its leadership in the trade arena and avoid restrictive trade practices both at home and abroad with renewed vigor.

The only one of these three steps that can be undertaken quickly is an end to rate increases by the Fed until the pace of growth becomes clear in coming months. With inflation and growth both falling, there is no inflation risk attached to a pause in Fed rate increases. We don't need a recession to tame inflation -- the usual rationale -- and we certainly don't need a recession that reignites deflation risks.

Mr. Makin, resident scholar at the American Enterprise Institute, is a principal at Caxton.

Ray Zee
10-19-2004, 10:43 AM
that institute is a right wing right way out politically avtive group. i wouldnt put any stock in that article. thats my opinion. besides with oil going way up how can inflation go down. oil drives the upward movement of price more than any other commodity likely.

10-19-2004, 11:34 AM
I'm a little surprised at yields on the long end of the yield curve in light of the economic data. Would you say the bond market has it wrong then? I really don't know and am trying to weigh all the evidence so I appreciate your thoughts as always. Here's an article about the CPI numbers today. CPI rose 0.2%, ex food and energy 0.3% which I find a little surprising but the article seems to indicate that a lot of that is due to rising hotel and motel rates brought about by the hurricanes in Florida. Greenspeak seems to be that oil will not have an inflationary impact but will also not have much of an effect on economic growth. At least that's my take on the meaning of recent Greenspeak.

Consumer Prices Rise 0.2%
As Lodging Rates Increase

Housing Starts Take a Hit in September,
But Building Permits See Surprise Jump
October 19, 2004 10:52 a.m.

WASHINGTON -- A jump in rates at hotels and motels forced U.S. consumer prices higher in September, but rising prices for crude oil didn't appear to be feeding inflation.

The Labor Department said Tuesday that its consumer-price index rose 0.2% last month, a somewhat more pronounced move upward after small increases over the last few months. The closely watched "core" index, which excludes typically volatile food and energy items, rose 0.3%, the fastest pace since April. In year-on-year terms, the CPI was up 2.5%, down from an increase of 2.8% in August.

The increase in the core index was larger than the 0.2% gain that Wall Street had been expecting, although the overall increase matched expectations. The Labor Department attributed "about three-fourths" of the increase in the core index to a surge in the price of lodging away from home, which climbed 2.9% -- the fastest clip since April. The jump in lodging rates was "perhaps aggravated by the sharp increase in demand because of the evacuations due to the hurricanes in Florida," according to Steven Wood of Insight Economics.

The numbers provided further evidence that surging oil prices haven't been a catalyst for a rapid increase in inflation -- a view held by Federal Reserve Chairman Alan Greenspan. Over the last year, crude-oil prices have risen more than 40%, setting a record of $55.33 a barrel last week, but consumer inflation has remained relatively tame.

Indeed, the Labor Department report showed that energy prices declined for a third month in a row in September, falling 0.4%. Gasoline prices rose 0.1% after several months of decline. Natural-gas prices fell 3.1% in the biggest decline since April 2003. Food prices were unchanged despite a 2% drop in dairy prices that was the biggest in more than five years.

Some economists expect that oil prices could become more of a factor in the months ahead, since futures prices tend to take some time to snake through to the marketplace. Also, the heating season is approaching, which will drive up demand for refined crude. But there is little expectation that consumer prices will come under serious pressure as a result. "Next month will be dominated by surging energy prices but the key point is that broad core inflation is very benign," said Ian Shepherdson of High Frequency Economics.

Housing prices, which account for 40% of the index, rose 0.2%, the same as in August. Transportation prices also rose 0.2%, rebounding after a 0.3% decline in August. Prices of new motor vehicles declined for a third month in a row, falling 0.2%. But medical-care prices accelerated, rising 0.3% after a 0.2% gain in August.

Separately, the Labor Department said the average weekly earnings of U.S. workers, adjusted for inflation, were unchanged in September as a 0.2% increase in average hourly earnings was offset by a 0.2% gain in the CPI for urban wage earners and clerical workers.

Housing Starts Tumble

Home construction fell much more than expected during September, but permits for future building posted a surprise increase. The Commerce Department said housing starts slid 6% to a seasonally adjusted 1.898 million annual rate. Economists polled by Dow Jones Newswires and CNBC had forecast housing starts would drop by 2.8%. Building permits increased by 1.8% to a 2.005 million annual rate. That too was a surprise to forecasters, who expected a 1.5% dip.

Some analysts see housing construction at a cyclical peak and have been forecasting its decline for some time. But starts and sales have run high this year. Mortgage rates have been relatively low, attracting new buyers into the market. Last month, the average 30-year loan held below the 6% mark after drifting lower in midsummer, according to Freddie Mac.

The weakness in starts spread across most of the U.S. housing market. Housing starts fell 27% in the Northeast, 4.6% in the Midwest, 1.0% in the South, and 7.9% in the West. The drop in the Northeast was the largest since starts tumbled 29% in May 2001.

Single-family housing starts took a dive, falling by 8.2% in September. Multifamily starts -- that is, apartment-building construction -- jumped 20%. Nationwide, an estimated 163,000 houses were actually started, based on seasonally unadjusted figures. An estimated 173,500 building permits were issued in September, also based on unadjusted figures

10-19-2004, 05:04 PM
Interest rates are still low. The real estate market has also changed. Large companies like Pulte are driving down the costs of building. Developers also have their own agenda, once they sell you a home they keep building others until there is a real estate collapse or interests make further developments impossible. Then they move on to a new town.

10-19-2004, 06:36 PM
I mean the low yields on the long end seems to indicate low inflation expectations to me.

Ray Zee
10-19-2004, 07:59 PM
adios, i think they have it way wrong. we have to see inflation. oil costs are up but greenspan as all reserve chairman always poo-poo stuff near elections. thats part of their job. or so it seems.
we might see a recession or even mild depression first but interest rates have to rise with inflation. prices and costs are up, no matter how they fudge the numbers.

10-20-2004, 02:07 AM
Good point about Greenie and the elections. I guess a bet on higher bond yields would be right at this juncture.

Ray Zee
10-20-2004, 10:39 AM
but it may be some time out yet before it happens. i dont see a way at present to make any money off it. except for maybe to transform your portfolio away from stocks that are interest rate sensitive. cash is looking like a good hold again.

10-20-2004, 11:39 AM
I understand that the macro economic effects can take a while to rear their ugly head. I also realize that the market shoots first and asks questions later, witness Countrywide's miss today and other stuff with dissimilar business models but same business segment getting killed in sympathy. So making bets on inflation may be premature. However, in an inflationary environment, at some point we don't want to be in cash I would think. But I realize that it takes awhile for perceptions to change. I'm trying to keep one foot at the exit door so to speak /images/graemlins/smile.gif.

10-20-2004, 12:18 PM
As to holding cash, the US$ is currenlty falling against most currencies.

The last of the bond bulls Hoisington management has a new report: http://www.hoisingtonmgt.com/HIM2004Q3NP.pdf

10-20-2004, 01:00 PM
Good article and seems to support the WSJ piece I referred to. It does seem to me though that higher energy prices are pervasive in raising the cost of consummer goods although I realize that it isn't the most important component of cost.

10-31-2004, 01:36 PM