Outstanding, must read.
Guest Commentary, by Richard Hastings
The Day the Fed Stood Still
April 7, 2004
Richard Hastings is retail sector analyst for a retail market advisory firm.
On the day when we expected it the least, The Fed stood still. It did nothing. It just stood by and watched. Here’s the incredible story of The Day the Fed Stood Still.
Almost as mysterious as a child’s idea of an alien space ship is the adult American’s idea of The Fed—the Federal Reserve System of the United States. We have become used to hearing about what The Fed will do in response to everything, about its powers. Indeed, we now believe The Fed is watching everything and that Federal Reserve Chairman Alan Greenspan is the most powerful man in the world. Mr. Greenspan’s reputation now rivals that of heroes of legend such as Genghis Khan and El Cid.
What can The Fed do with all of its powers? “Gort could destroy the world.” Would The Fed, and why?
Every time we hear about economic growth, we hear something about The Fed’s possible reaction to faster growth, about its specially formulated “monetary policy”. Or, “The Fed might start raising rates.” Every time we hear about slow growth, we hear about The Fed’s monetary policy to stimulate the economy. “The Fed can help out by easing credit.” We live in a culture dominated by anticipation of possible Fed reactions to everything. We watch them more than they watch us.
Now let’s take a serious look back at The Fed.
The Fed does not operate in a vacuum. It works with The Department of the Treasury and its Bureau of Printing and Engraving to perform its wondrous deeds. The Treasury helps out with the debt securities to fund the paper money that The Fed tells the Printing and Engraving Office to print and circulate throughout the country. “The Fed prints money” and “The Fed controls interest rates.” Neither is true. The Fed sends instructions to the Treasury regarding the printing of money, but it does not exclusively control this action. When money supplies grow, The Fed is busy doing its best, most influential work. Between January and February 2004, M1, the best measure of currency supplies, grew $78.5 billion. The Fed is good at this. You wish they could do it for you, personally.
The Fed talks to major commercial banks, does research, talks to other central banks in other countries, and The Fed buys and sells dollars in exchange for other currencies. If the yen looks like it is rising too fast against the dollar, then The Fed can step in and with some help from The Bank of Japan, The Fed can sell Japanese yen and buy dollars, thus moderating the exchange rate and influencing the prices we pay for goods and services.
Perhaps, in a perfect world, we would be paying much more money for TV’s. Maybe we should, considering how important they are to us. But The Fed seems to believe we should pay less for TV’s—and everything else. They decide how much somebody else gets paid for something we treasure. You may believe in free markets but it is more important to have any type of market including those in which prices are controlled. Just be careful what side of the transaction you choose, especially if you make TV’s. You might get paid too little. Like China did before their currency was floated in the global currency markets, unhitched to the dollar (it will be explained this way after it happens).
The Fed knows that inflation can slow down the economy because inflation reduces the value of assets, and inflation undermines business confidence. The Fed also knows that the mere thought of inflation can slow down the economy. The Fed worries about this as a matter of policy: “At other times, policymakers may be concerned that the public’s expectation of more inflation will get built into decisions about wages and prices, become a self-fulfilling prophecy, and result in temporary losses of output and employment.” (The Federal Reserve System, Purposes and Functions, 1994).
While The Fed has been busy concerning itself with the public’s and business world’s perceptions of the mere possibility of inflation, it has done an awful job of preventing inflation from occurring. Despite all of the efforts of government economists to tell us that inflation is tame, over the past four years, consumer prices for prescription drugs, food, and energy have increased steadily. These are things we need. We use TV’s. We like TV’s. But babies need milk. Now we are getting beyond the steady inflation phase and into the serious phase.
These are the slowly moving, inevitably inflationary pressures building up in the consumer economy of the U.S. Retail gas inflation is now turning into disorderly, chaotic price inflation. But there is something much more substantial and dangerous behind this. It is severe inflation in commodity prices globally—regardless of the effects of currency translations between the declining dollar and rising currencies that are rising against the greenback. If the dollar were to drop by 80 percent against the yen, I guess we should be making currency translation adjustments for the price we pay for commodity imports because the dollar should not be that low and imports should not be that expensive. Instead, just skip the calculations: we’re paying more. The Fed may think somebody should be paid less, just like TV’s. But somebody is getting paid more dollars for soybeans and crude oil.
While price inflation in the consumer sector is sometimes gradual, the price inflation in the producer and wholesale sector is significant and it is disorderly. The most recently published Producer Price Index, for January 2004, is filled with double-digit dangers. Here are just a few:
§ Iron and steel scrap, +72%
§ Soybeans, +52%
§ Raw cotton, +41%
§ Copper, base scrap, +33.6%
Source: Bureau of Labor Statistics, Produce Price Index, rate of price index change from same month one year ago.
A recent editorial by Tom Stundza, Executive Editor of Purchasing Magazine, a publication specialized in industrial supply chains, put it in the starkest terms. “Prices have risen across most steel product lines. But, steel buyers are having the hardest time getting a handle on market prices for sheet and plate products: Sheet pricetags in February have jumped 30% in a year, and mill suppliers continue to adjust future prices upward so that market prices in April could be 60% higher than a year earlier.”
The chaos he describes is now headed our way—and that means me and you, Joe Consumer. Thanks to runaway inflation in retail gasoline and a phenomenal rise in demand globally for goods and services for a world population rapidly moving in on 6.4 billion people, we are facing the most severe inflationary crisis since the oil embargoes of the 1970’s. It should be worse, mostly because credit inflation is bullish for goods price inflation. Credit is the foundation of speculative capital, and inflation is its offspring. It is growing up while we watch TV.
And in the face of this crisis do not expect the usual. Do not expect The Fed to do something about it. In the prior generation—when The Fed was more independent and was not omnipotent—it responded to rising prices by increasing the cost of borrowing money and reducing the amount of circulating currency, thus slowing down the rate at which supply chains passed along rising prices and preventing damaging forms of price competition (a natural occurrence during inflationary cycles). Yes, the economy slowed down along with it, but at least you could put some money into safe investments like money markets and U.S. treasuries and earn double-digit, guaranteed returns. No deflation, just safe, high-yielding safe-haven savings. All of that is now gone.
In its place today is a financial system that is structurally, theoretically, and actually flawed. Stocks are at risk, especially non-dividend bearing mid- and small-cap issues. Even dividend bearing stocks could suffer because of the effects of inflation upon the value of dividends over time. What may look like a good dividend yield today would calculate itself as a negative yield if consumer inflation rises beyond the 6% annualized threshold. Indeed, the aggregate yield on most stocks is already in negative yield territory. Bonds, especially treasuries that are currently in a deflationary crater of negative yields, would be pummeled into discount prices, creating huge losses for the biggest institutions that have used the bond markets for stability and safety for years. This points directly at the reason why The Fed Stood Still.
We are a credit market/housing market economy completely dependent upon low rates for its survival. It goes like this. Consumer spending depends upon credit and the housing markets, not jobs. That’s why people are still shopping although job creation is almost non-existent. The housing market, in turn, is totally dependent upon the international collateralized bond markets and credit markets. These markets are conjoined to the speculative capital markets of international finance, a world without borders or time. The macro innovations are fascinating, but the local effects are disturbing. United States household credit market debt is now estimated at about $9.4 trillion. Aggregated personal savings (an effortful attempt at finding out how much money is left over in the household sector after expenditures) is estimated at a hilarious $165 billion or just 1.9% of disposable income. Cash is not king here. The Fed is king and credit—something The Fed creates beautifully—remains the most powerful and influential source of spending and safety for the U.S. household.
The Fed (again working with The Treasury and the GSEs) has everything to do with this phenomenon. Credit markets dominate, and rates must remain low in order to create the margin spreads that have flushed the banking system with profits. The FDIC’s Quarterly Banking Profile says their members posted more than $120 billion in income for 2003. Much of the industry’s strength comes from its largest consolidators like Bank of America and Citigroup. The timing could not be better. The banking system needs to be strong, because Joe Consumer is not. The FDIC’s fourth quarter report clearly indicates gathering momentum in the inevitable unraveling of the U.S. household dependence upon credit. Here are just some of the negative developments:
§ Charge-offs of residential mortgages, up 93.7% in Q4’03 vs. Q4’02
§ Non-current credit card loans up 44.0%
§ Credit card loans past due 30-89 days up 41%
If you ever wonder why the consumer has so little cash left over from disposable income, it is because the average consumer leans on credit to spend in excess of his and/or her capacity. Credit has artificially boosted spending and knocked down cash savings. When the disorderly inflation comes later this year, the average household will make a choice somewhere between a reduction in personal consumption expenditures and an increase in cash savings. One leads to the other. Credit will quickly decline in charisma.
The Fed has not been sleeping. Greenspan, The Fed, and the banking system they serve would like more consumers to enter into adjustable rate mortgages so the banking system can increase rates to borrowers when and if The Fed increases the overnight rate. That comment from Greenspan, on February 23, 2004 to the Credit Union National Association 2004 Governmental Affairs Conference in Washington, D.C., was the most obvious signal that The Fed will remain committed to credit.
“Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward” – Alan Greenspan, Feb. 2004.
Luckily for most mortgage holders, their rates are locked in. But home equity lines of credit and consumer credit cards are based upon adjustable rates. Lenders can adjust those contract interest rates quickly. The Fed should not worry because they can increase rates on financial instruments other than most fixed mortgage contracts. Indeed, they’ve already done that, and the banking system thinks this is a good thing to do. That is a big trouble spot especially if you enjoy the contribution of consumer spending to GDP.
If The Fed raises the overnight rate this year in response to higher consumer prices, the housing and credit markets will retreat—to put it in the kindest terms. Consumption represents 71% of GDP, so any impact on the household sector will instantly convert into lower GDP growth and maybe worse. Lower quality consumer credit borrowers—those with FICO scores below 600—would find themselves struggling to get enough credit. Penalties for late payments would go up and credit limits would come down for the lower quality borrowers. Contract annual finance charge rates would go up, and for many consumer borrowers their card prices are already high. Spending would require more cash than credit, and it won’t be there. Jobs and better wages will probably not be there, either. Rates on home equity credit would go up even higher, and the lowest quality consumer borrowers would find themselves shut out of the credit markets—sharply reducing their spending capacity for discretionary goods and automobiles. The credit market would turn against itself.
When the inflation comes, and prices start to pass through supply chains like what is happening to the steel markets, companies may start double-thinking their contracts and cancel orders, thus reducing a source of employment in the wholesale sector. Companies are not stupid. They know that they have to price-in their costs and expenses to stay in business. This is why profits matter. Otherwise, it makes no sense to build product and not be able to price it to cover costs and expenses—something that inflation reverses and makes difficult to achieve. Without much recent experience with inflation, there is the risk that accountants, consultants, businesses, and households will hypothesize their way through the inflation. They probably won’t know what to do, so they’ll guess they do.
As disposable income gets absorbed by rising consumer prices, the pressure will be there to increase the return on savings. Households will become interested in cash—a real novelty. Meanwhile, The Fed will remain loyal to the credit markets and not the savings/cash markets. The Fed could slowly decrease M1 growth, but it would not want to compound this with higher overnight rates. Supply chains will back off of expansion because prices will go up too fast on the goods they need to build the materials for their orders. Delivery costs will increase, putting pressure on the transportation sector’s ability to share the inflation.
A brilliant man once told me this economy is built on two things: cows and autos. The cows make the milk and meat that goes on the trucks and gets delivered to supermarkets where consumers come in cars to bring home the bacon. And the trucks delivery the fertilizers and feeds that the cows need to grow and make the milk and meat needed to feed hungry truck drivers. Babies need milk, children like meat, and everybody likes to go to the store—usually by car. The circle is complete. Throw in gas inflation, and the circle will quickly pass along the hot potato.
The Fed worries a bit about this. People and companies can always reduce their expenditures without Fed intervention. The Fed is clear: it does not want the housing market and credit markets to crack. The Fed worries about rising TV prices but not nearly as much as it is worried about the trillions of dollars in notional derivatives that underpin the credit markets and interest rates. The collateralized bond markets float upon a jet stream of derivatives.
This frightening scenario is neither far-fetched nor far from taking place. When gas hits $3.00 a gallon, we will remember that day as The Day the Fed Stood Still. |
