Being Street Smart 6/30/6

BEING STREET SMART
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Sy Harding


SLOWING ECONOMY, RISING INFLATION – BAD! June 30, 2006.

And I don’t mean bad in the context of current teenager slang in which “that’s bad” means “that’s cool”! A slowing economy and rising inflation is not cool. In fact it is potentially the worst of both worlds for the stock market.

As was widely expected, the Fed raised interest rates another 0.25% at its FOMC meeting on Thursday. It was the seventeenth timid 0.25% hike in a row over the last two years, yet raised the Fed Funds rate to only 5.25%. It has been my forecast for almost two years now that the Fed will not be able to stop raising rates until the Fed Funds rate is at 5.5% to 6.0%. Since these timid increases are not doing the job of bringing inflation under control, I suggested in last weekend’s column that the Fed should bite the bullet and come in with a more aggressive 0.5% hike this time. That thought gained some advocates in the investment community as the week progressed. But the Fed chose to go the timid route again.

That keeps the debate alive as to if and when the Fed will be able to stop raising rates.

In its announcement accompanying Thursday’s hike the Fed provided fuel for both sides of the debate, even though only the bullish side was noticed in the market’s initial reaction on Thursday. At its rate hike in May the Fed said that “Economic growth has been quite strong this year.”, which scared the market by indicating the Fed felt it had plenty of room to hike rates further to ward off inflation without having to worry about slowing the economy too much. At its rate hike Thursday that phrase was changed to, “Recent indicators indicate that economic growth is moderating.” The market was convinced that means the Fed will only raise rates maybe one more time for fear of slowing the economy too much.

I believe it still has a ways to go with the rate hikes. Why so? On the inflation side, prior rate hikes were accompanied by statements saying that inflation remained benign, or “under control”. That phrase was also changed with this week’s announcement, to, “Readings on core inflation have been elevated in recent months.” That could just as well have driven the market to the downside on concerns that the Fed realizes it is not winning the war on inflation and will have to continue raising rates for the foreseeable future.

However, I believe a half dozen words in the rate hike announcement were given too much credit for the market’s big rally on Thursday anyway. The rally was at least as much due to the market’s short-term oversold condition, especially after Tuesday’s big triple-digit decline, coupled with the strong tendency of the market to be up in the final couple of days of a quarter as money managers engage in the practice of portfolio ‘window-dressing’. Those influences were obvious in that the market was already up strongly from the open on Thursday, before the rate hike was announced mid-afternoon and gave it a further boost.

It should be interesting to see what happens in the latter half of next week, after the effect of window-dressing and the short-term positive period around the holiday is no longer an influence. I suspect that hedge funds and other big money-managers will be poised to move back to the sell side at the first sign that the rally has run out of steam.

My reasoning for that thought is that the Fed’s additional timid rate hike on Thursday did nothing to change the predicament in which the Fed finds itself, or in the outlook for interest rates, inflation, the economy, or corporate earnings. This time the Fed even admitted its situation, saying that economic growth is already moderating, while core inflation is rising.

So the market still must face the problem that the Fed will have serious inflationary pressure on it to continue raising interest rates, slowing the economy further, even at the risk of slowing it all the way into recession as it has done so often in the past. The alternative would be to slack off on the rate hikes and allow inflationary pressures to rise even further, with the even more serious effect that would have on the economy.

The Fed’s rare predicament of having to deal with a slowing economy and rising inflation at the same time, was not alleviated by the closely watched Chicago Purchasing Manager’s Report, released the day after the rate hike. The CPM’s index declined to 56.5% in June from 61.5% in May, a much larger decline than expected. A number above 50 indicates the economy is still growing, but the closer it falls toward 50, the slower the growth. At the same time the index’s ‘prices paid component’, a measure of inflation, went through the roof, leaping from 76.9% in May to 89% this month, indicating manufacturers are facing sharply higher costs that will likely be passed on to consumers in future months.

An already slowing economy, with rising inflation calling for still more interest rate hikes. Not cool!


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.