Inflation, Interest Rates, and the Fed

Inflation, Interest Rates, and the Fed

November 2, 2005

I had a Squawk Box gig this morning talking with Mark and Steve about inflation, interest rates, and the Fed. As you know, the Fed raised their Fed funds target for the umpteenth time yesterday to 4% and Ben Bernanke, who will likely take over as Chairman when Alan sails into the sunset, told reporters the Fed would likely keep raising rates until they saw signs that the economy was slowing (i.e., after it is too late). some points we raised this morning:

1. Mark asked if this proves the Fed targets growth, not just inflation as they claim. Answer–yep. And it also means that Fed policy is determined BY the economy, not the other way around. In other words, the Fed is mainly a spectator to economic events. They spend most of their time cleaning up their own messes.

2. Why is the economy still so strong (as shown in recent economic reports) after all that tightening? Answer: It’s not the rates that make recessions, it’s credit availability. There are 2 economies, not one. There’s the Public Economy made up of big public companies, and the Private Economy of mom and pop businesses. Public companies care about rates but not very much. In 35 years I have never seen an investment decision made or rejected because short term interest rates were a couple points up or down. Private companies, more than half of GDP and 70% of jobs, don’t care about the rate; they care about whether they can get credit at all.

Right now these companies are drinking from a fire hose of credit, a situation that began in May 2004 after a 4 year credit drought. That’s why the Fed has not been able to kill the economy–yet. Mom and pop are alive and well and hiring people.

3. What would the Fed have to do to kill the economy today? Answer: The way Fed policy hits the economy is by tightening over and over again until they break something, which leads to a non-price credit rationing situation similar to a blackout of an electricity network. Examples include the S&L crisis, the highly leveraged transacions (HLT) tightening, and lending collapse that followed the dot com bust. If it happened today it would be triggered by a major corporate bankruptcy, or a sudden mortgage market event (changed regulations, changed tax treatment).

4. How hard will it be for the Fed to contain the inflation they are worried about? Answer: slam dunk. While everyone is looking at rising oil prices there is a sleeping giant of deflationary pressures in the balance sheets. The Delphi, GM, and airlines headlines all indicate the presence of liabilities that cannot be serviced in today’s competitive global economy. Their resolution will involve asset sales, which will pull fixed asset prices lower. Wage differentials between the US and China do the same thing. In last week’s economic cost report we saw that real wages for US workers fell 2.4% last year. That is not the stuff inflation is made of.

5. Conclusion: Bernanke is going to have an easy time containing inflation. Some time in early 2006 I expect the Fed to be driven off of their rising rate rhetoric. When that happens I want to own US equities.


John Rutledge

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