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[TTHQ Staff]

BEING STREET SMART
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Sy Harding


ARE INTEREST RATES HIGH ENOUGH? December 9, 2005.
The Federal Reserve has raised interest rates 12 times over the last 17 months in its efforts to ward off inflation. It will hold its next FOMC meeting Tuesday, at which it will decide whether to hike them again. The consensus expectation is that it will, but that it will also indicate it is finally ready to end the rate-raising cycle.

Could the Fed possibly believe it has inflation under control? It’s true that crude oil and gasoline prices have dropped dramatically since the hurricane season ended. Gasoline was $3 a gallon in October, and is now ‘only’ $2.15 a gallon. But did that quick spike up and back down change anything in the long-term price trend? Not at all.

The price of crude oil was $20 a barrel at the end of 2001, $33 at the end of 2003, $42 at the end of 2004, and $57 pre-Katrina in 2005. The hurricane fears spiked it up to $74 a barrel, but as those fears subsided, oil prices just as quickly pulled back. But they only pulled back to their pre-Katrina rising trend, pricing this week just above $60 a barrel. So it looks like at least the four-year rising inflation trend in energy costs continues unabated.

Inflation was rising at a pace that had the Fed concerned 17 months ago when it raised rates for the first time in this cycle. It was still concerned when it raised rates for the twelfth time last month, worried that the economy was still too strong to allow inflation to be brought back under control. So it raised rates again even though fears were rampant at the time that the hurricanes had already slowed the economy significantly. The Fed correctly predicted the economic effect of the hurricanes would be temporary, and as we have learned from recent economic reports, the economy has indeed bounced back dramatically.

Yet another situation that must have the Fed’s attention regarding inflation is the dramatic rise in the price of gold. For hundreds of years, rising gold prices have been taken as a warning of increasing inflationary pressure. During the economic boom times of the 1990s Fed Chairman Greenspan often noted that inflation was declining and not a threat, citing the continuing decline in gold prices as a confirming factor.

The price of gold has now been rising since 2001. It was no coincidence that in 2001 the CRB Index of Commodity Inflation also began showing what has become a stunning four-year rise in inflation of commodity prices. The CRB Index was at 185 in late 2001, and has almost doubled to 340 since. Meanwhile, gold, which was at $250 an ounce in 2001, has more than doubled, to $525 an ounce, over the same period.

Earlier this year I predicted rising inflation would help gold reach $500 an ounce, but not until early next year. But speculative fever hit the gold sector late in November, and by last week gold had already reached my target, and kept right on going. While that extra emotional burst may have gold overbought to some degree, the Fed must have noticed what gold is saying about whether the Fed has inflation under control.

However, there is one area that should cause the Fed to at least consider ending the rate hikes. That is the situation in the real estate sector. The Fed’s previous rate hikes finally have mortgage rates high enough that the rampant speculation in real estate is cooling off, but if that sector weakens further and the bubble completely bursts, it will significantly slow the economy and inflation, perhaps too much, without any further rate hikes.

So the question is whether the Fed will put more weight on what the spiking price of gold is saying about inflation, or on the risk that further rate hikes might guarantee the bursting of the real estate bubble.

It’s interesting to look back at the Fed’s decisions in another bubble period, when it was also raising rates in 1999 to slow that economy and ward off inflation. At the time there was an investment bubble in the stock market that had the Fed worried. Yet when the Dow topped out in January 2000, beginning its severe 2000-2002 bear market, the Fed was still not convinced its job was done regarding inflation. It continued to raise rates for another four months. Combined with the bursting of the market bubble, the further rate hikes slowed the economy all the way into the 2001 recession.

Perhaps the Fed will be convinced earlier this time that an investment bubble has seen its peak, and that its bursting would be devastating for the economy.

There is yet another situation that could prompt the Fed to signal an end to rate hikes after the hike expected on Tuesday. Greenspan is retiring in January. He would probably like to end his long career on a high note, with the economy and stock market rising, and consumers and investors happy. There would be no easier way to accomplish that than to signal an end to rising interest rates, and let the next Fed Chairman worry about the consequences.

And perhaps that is just what the extra spike up in gold is predicting, that the Fed is about to signal a halt in its fight against rising inflation.



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.