Being Street Smart 6/23/6

BEING STREET SMART
___________________

Sy Harding


HOW THE FED GOT BEHIND THE CURVE. June 23, 2006.
Two years ago this month the Federal Reserve began raising short-term interest rates in an effort to slow the economy enough to prevent inflation from getting out of hand. It’s widely expected to raise rates again, for the seventeenth hike in this series, at its FOMC meeting next Tuesday. It has been one of the longest such efforts in history.

Yet with both the Producer Price Index (PPI) and Consumer Price Index (CPI) showing much larger increases in inflation in May than had been forecast, there are no signs yet that the rate hikes are getting the job done.

Looking back at previous such periods, in its efforts to ward off inflationary threats in the even more robust economy of 1999 and 2000 the Fed needed only six rate hikes to get the job done. In the early 1990s it was satisfied it had achieved its goal after only seven rate hikes.

So what has been different this time around?

The most obvious difference is that the Fed was further in the hole when it began this rate-hiking series. In its desperation moves to get the economy moving out of the 2001 recession, with the 2000-2002 bear market in stocks still underway in the background, the Fed cut interest rates to levels not seen since the 1950s. With the Fed Funds rate at 6% in early 2001, it had cut the rate to a 50-year low of 1% by 2003.

So the first hike in this series, made in June, 2004, only raised the Fed Funds rate from 1% up to 1.25%, a level that was still stimulating economic growth, not acting to slow it. After nine such hikes, it had the Fed Funds rate up to only 3% by June, 2005, and it was beginning to get behind the curve, with inflation showing up in numerous areas, notably in commodities. Even after sixteen such hikes over the last 24 months, the Fed Funds rate is still only up to 5%.

Compare that to the situation, and the Fed’s aggressiveness and determination, in its rate hiking cycle in 1999-2000. The Fed Funds rate was already at 4.75% when it began hiking rates in that cycle, and after only six hikes, it had the rate up to 6.5%, which got the job done.

In its previous rate-hiking cycle in the early 1990s, the Fed Funds rate was already at 3.0% when it hiked rates the first time in that series. It had to get the rate up to 6.0% before it was satisfied it had the job done. But it took only six hikes to get there. After raising rates a modest 0.25% three times, and seeing it was not getting the job done, the Fed became much more aggressive, moving to three hikes of 0.5%, and even one triple-dose of 0.75%.

This time around, for whatever reason, the Fed has been much more timid, raising rates only 0.25% sixteen times in a row, taking two years to get the Fed Funds rate up to only 5.0%, when history indicates that it will have to be at least 5.5% to 6% to get the job done.

Meanwhile, with two years under the bridge without getting the job done, the Fed finds itself further behind the curve. As the May PPI and CPI reports show, inflation has been increasingly getting out of the bottle, and as history clearly shows, once out it’s more difficult to get it back in than it would have been to keep the stopper in the bottle from the beginning.

So why has the Fed been so timid this time?

Its timidity probably stems from concerns about the macro-economic picture casting a shadow over its efforts this time. The risk of slowing the economy too much may be more than only the normal risk of overshooting the economy beyond the hoped-for soft landing into a mild recession. The real estate bubble, record consumer debt, record Federal budget deficit, record current account deficit, unknown situations with the leveraged derivatives risks of hedge funds and banks, probably has the Fed realizing that this time around the risk is of much greater damage if it fails to guide the economy and inflation in for a soft landing.

It leaves the Fed in a tough situation. If it continues to act timidly with only 0.25% rate hikes each time, and the Fed Funds rate needs to get up to 6% before it affects inflationary pressures, we would be looking at three more hikes beyond next week’s. That would mean sometime next fall or winter before the markets would see the hoped for end to the rate hikes. That would also be more months for inflation to become an even larger problem.

Perhaps what is needed is a more aggressive 0.5% rate hike next Tuesday.


Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.