THE ECONOMY:
Consumer prices rise, but core is flat less energy.
April prices rose 0.5% overall, more than the 0.4% expected. Gasoline rose 6.4%, power 6%, housing 0.3%, and medical care 0.2% (a much more modest rise for healthcare). Take out food and energy and prices were flat, reflecting the beginning decline in oil prices. Significantly, gasoline prices were still up 6.4% in April, making up a large part of the overall CPI gain. Prices for oil and gasoline did not start their real decline until very late that month, however, and thus the CPI is likely to show even less inflation in May.
Disinflation starting again?
The numbers are leading some to already say that prices have peaked and thus we have seen the apex of inflation. Bill Gross says the 10 year treasury is going to hold 3% to 4.5% for the next five years; that is anything but inflationary. Indeed, there is talk of disinflation once more, the phenomenon the economy saw in the 1990's even as economic growth spurted. This is not deflation where asset values decline, but prices of goods not rising even as demand remains solid. Healthy growth without inflation; that is precisely what happened in the 1980's when the Regan tax cuts and deregulation took the chains off the economy and reawakened investment in the US. Capital was unlocked by the billions from tax shelters designed to protect money. When that hit the economy the 20 year boom started.
During that time interest rates started their decline. They fell all through the mid to late 1980's but then started to rise in the mid-1990's following the Bush 1 and Clinton tax hikes. As the deficit turned to surplus, interest rates hit their highest levels since the end of the early 1980's recession. That flies in the face of the Robert Ruben theories about deficits 'crowding out' private investment by driving up interest rates. History shows precisely the opposite happened, i.e., interest rates rose and the economy started to suffer. Combine that with the Fed rate hikes and you had a market collapse and economic recession.
You never hear the mainstream report why this occurs, particularly those who prefer higher taxes and government spending to lower taxes that keep the money and thus the investment decisions in private hands. What happens is this: when tax rates are too high they take too much money from the economy. When there is a surplus that is only indicative that the government is taking way too much money from the economy. That is real money taken out of your pocket and your business' pocket, not the government's deficit money that it basically prints at the Treasury. The government took that money out of circulation and used it to pay down the funny money it created. Good money used to replace funny money.
That made money more expensive because there was less money in the system because it reduced the money the real world, the small business world, uses to finance new business. Interest rates rose even though prices overall were still in a disinflation mode. That was unsustainable, and as stated, when the Fed took aim at the stock market and dried up the rest of the money supply, the combination crashed the market, forecasting the economic recession that was to come.
As I have been stating, this cycle is trying to start again. The disinflation is not a bad thing at all. It is very good for the stock market. The problem is the Fed hiking rates and draining money supply into a slowdown and disinflation. The Fed has a problem recognizing prosperity founded in tax cuts and less regulation as opposed to economic surges in periods of higher taxes, high regulation, and high interest rates. In short, it looks at every economic period through the Phillips Curve prism even though that theory only worked for about 6 years in the entire history of economics. At this point in our understanding of economic history, you would think that the Fed and certain members of Congress would start to realize that the Phillips Curve was the rare exception and not the rule in economics. All economics textbooks from the late 1970's and early 1980's should be burned or at least taken out of the hands of the Fed members and some in Congress.
I was very concerned about inflation sparking in this recovery. It was starting as demand was leading supply. Then the soft patch had more impact on demand than I thought and it appears that supply and demand are evening out a bit. It still is not there, and supply still needs to get stronger to avoid any real inflation growth. The recent signs are positive, however, and if we can get over this demand bubble and let supply catch up, the expansion could extend further even with a normal slowdown in this 2.5 to 3 year range in the recovery. In other words, it would be normal for an expansion to slow some 3 years from its start, but if supply and demand are roughly at equilibrium, that would allow the expansion to continue just as it did in the 1980's and 1990's after it hit slow spots.
What to do about the Fed.
The problem remains the Fed. It has a penchant for not recognizing this type of growth paradigm. Greenspan talks a good free market game, but when it is time to execute he falls back on defense. He keeps the real hawks in check, but to do so and avoid mutiny on the Fed he has to walk a zig-zag line. We are definitely giving him the benefit of the doubt here, but we do know there are some real hardliners on the Fed, married to the Phillips Curve. They would have rates at 5% right now if they could.
Some will argue that the Fed needs to keep hiking, but as we have discussed of late, the key indicators are saying there is not any expectation of inflation, and indeed they are getting closer and closer to predicting the Fed is going to go too far. Gold is trending lower, hardly a sign of inflation. The treasury spreads are getting very thin. Four months ago they were 400BP. Eight weeks ago it was 200BP. Today it was 100BP as the 10 year closed at 4.087%.
This is not signaling inflation. The Fed needs to acknowledge these historical indicators and not stall the economy before the recovery reaches its potential. The Fed should let us get back as close to full employment as possible. It should let the tax cuts continue to do their work to repair the damage done in 2000 to 2002. We have a lot of recovering still to do, yet the Fed is ready to turn off the switch before we get there.
The main rub or problem for the market is the Fed's target for rates. It denies it has a target, but it is not going to rest below 4%, and 4.5% is more likely. The Fed may believe inflation pressures have moderated (though to be clear there has been NO statement to that affect; indeed the opposite as the Fed feels without its rate hikes inflation would be out of control), but there is that other reason the Fed was raising rates to begin with: they are too low for the Fed to be able to provide the symbolic stimulus of cutting interest rates of something major occurs that would negatively impact the economy.
The Fed was already cutting rates when 9-11 hit. It threw a 50 BP cut in the mix immediately, and then another one later that year. It was something of Murphy's Law, Fed style. The Fed embarks upon these rate campaigns and then the unexpected happens and the Fed has to really backtrack. That left rates really low; the Fed had no ammunition. Now the Fed needs to get rates back up so it can cut and show the world it means business in keeping the world economies afloat. We call it symbolic because rate cuts don't do much near term other than show everyone the Fed is in the game, doing what it can to end the crisis.
Thus the Fed is likely going to keep on hiking until it gets to 4.5% regardless of what the economy does outside of a marked and obvious drop. Therefore other actions (or in some cases inactions) that are necessary. Primarily the Fed needs to get its foot off the neck of money supply. The Fed can hike rates all day to get them higher so it has the ammunition it feels it needs and still not really damage the economy AS LONG AS it keeps the money supply at growth levels. That is the opposite of what it did when it helped crash the market and economy in 2000. It raised rates and also drained the money supply pool. The economy vapor locked. Then later, even when it reduced rates it still did not let money flow increase. Thus even if you wanted the month at those rates you could not get it. That is why there was no response to the rate cuts and why the phrase 'pushing on a string' was used. If the Fed had let money supply expand then the money would have been available at those low rates. It waited too long and thus was ineffective.
Further, the Fed action needs to be offset by keeping the tax rates lower, reducing regulation further, lowering government spending, fixing social security so we are not paying into the government (yes that means private accounts) so it can blow the money on the Cowgirl Hall of Fame, and instituting a flat tax at 11% to 12%. That would insure continued growth and indeed work to create a new explosion of investment in the US as even more money that is sheltered from taxes is pulled out and put to work in the economy. Moreover, it is the kind of growth that we need in that the investment of those dollars would be into supply and continue the low or no inflation growth cycle that we have been able to enjoy since the early 1980's and just about blew with this last recovery. As for the 12% rate, that is key; if it is higher than that it won't get the support it needs, it won't unlock the sheltered funds because the incentive is not there, and it won't be equitable because they will back door loopholes into the system to make simply make it a progressive and regressive tax all in one. In any event, with these steps the Fed can hike rates and still keep the economy expanding much better and provide the chance for everyone who wants to take part in the prosperity.
Of course that is somewhere between Wonderland and Oz with respect to us getting there. The one thing that can be done is the Fed keeping its foot off of money supply. Right now it has not done that, and its history shows it hikes rates and clamps down on money supply; when it cuts rates it waits to open up money supply. If it follows the standard playbook as it is doing, that will come back to bite the market despite the solid gains and move Wednesday. |
