Being Street Smart 8/4/6

BEING STREET SMART
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Sy Harding


IS THE FED’S CHOICE INFLATION OR RECESSION? August 4, 2006.

A little inflation (rising prices) is usually a good thing for the economy. Businesses have so-called ‘pricing power’, that is the ability to raise their prices some to cover higher costs. Therefore wages can rise some, encouraging consumers to spend, without the higher wages affecting corporate earnings. Good times!

However, inflation that begins to rise too fast brings concern it might spiral out of control, with wages unable to keep up with rising prices. The resulting decline in the buying power of a country’s currency can be disastrous for its economy. Extreme examples include the 30% per month inflation in South American countries in the 1970s, and Germany in the early 1900s, when it took a wheelbarrow full of almost worthless paper money to buy a loaf of bread.

Jens O. Parsson put it this way in his 1974 book, Dying of Money:

“The effects of early inflation are all good. There is steepened money-expansion, rising government spending, increasing government deficits, booming stock markets, and spectacular prosperity, all in the midst of temporary stable prices. Everyone benefits, and no one pays. Later in the inflation cycle [if prices are allowed to rise too fast] the effects are all bad. . . . There is faltering prosperity, tightness of money, falling stock prices, rising taxes due to still larger government deficits, now accompanied by soaring prices and the ineffectiveness of traditional remedies. Everyone pays and no one benefits.”

Thus does the Federal Reserve make every effort to prevent inflation from getting out of control by trying to stifle it early, while traditional remedies can still work.

The Fed’s traditional remedy to fight back inflation is higher interest rates, which make it more expensive and difficult for consumers and businesses to buy goods and products, the lower demand making it more difficult for businesses to raise their prices.

Yet, it often happens that the Fed finds it difficult to apply the remedy, to raise interest rates just enough to slow the economy some and ward off inflation, but not so much as to slow it all the way into a recession. More often than not its doctoring fails, and the patient winds up in intensive care.

Investors have been witnessing the Fed’s doctoring in the current cycle for some time, with concerns rising that the Fed has already gone too far with the rate hikes to prevent the economy from slowing into recession, while at the same time it may not have gone far enough with the rate hikes to bring inflation back under control.

One problem has been that so much of the inflationary pressure has come from the tripling of oil and other energy costs, over which the Fed has next to no control, and on which its interest rate hikes have little effect.

The result, as I have been noting in several recent columns, is that the rate hikes have worked to slow the economy, perhaps too much, but have had no effect at all on rising inflation.

That unfortunate scenario continued in the economic reports released this week, with more confirmations that the real estate slowdown is accelerating, while the monthly jobs numbers for July, released on Friday, showed even fewer new jobs were created than economists forecast, the fourth such month in a row. And the unemployment rate rose unexpectedly, from 4.6% to 4.8%.

That kind of data would normally persuade the Federal Reserve it has gone as far as it dares in raising interest rates if it is not to bring on the next recession. After all, it takes six months or so for higher rates to filter down and affect the economy, and with a slowdown already underway, the Fed’s last three or four hikes have yet to have their effect.

However, the jobs report also showed inflation, previously confined pretty much to oil and commodities, is now also creeping into the wage side of the economy, with hourly wages rising 0.4% in July.

So the debate that has raged as each of its past FOMC meetings approached, is again in full voice. Will the Fed raise interest rates again at its FOMC meeting on Tuesday, or will the economy slowing faster than was thought cause it to halt the rate hikes?

In previous months I have come down each time on expecting more rate hikes, simply because the Fed usually fears inflation more than a recession. It knows how to get the economy out of a recession, by simply cutting interest rates as aggressively as it needs to. But it does not know how to get spiraling inflation back in the bottle once it allows it to get out.

I believe the inflation fear will win out again this time, with another rate hike taking place on Tuesday, but I’m not quite so sure this time. Those weakening economic numbers, particularly in the all-important real estate sector, and in the employment picture, are becoming ominous.

If the Fed does decide to pause this month in its rate hikes, you can be sure that in its announcement after the meeting, it will keep the door open for future hikes should inflation continue to be a problem. And that will keep investors on edge and still guessing, still concentrated too much on what the Fed might do, and too little on what the slowing economy means for corporate earnings going forward.



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.