Any Merit to Interest Rate and Inflation Concerns?

February 19, 2010 Edition, Volume IV

Inside Signature Update

- The Market – Interest Rate Excitement from the Fed
- The Economy – Inflation’s Simply Not on the Horizon


THE MARKET – Interest Rate Excitement from the Fed

The DOW closed slightly higher in moderate trading on Friday following the Federal Reserve’s announcement that it would increase the Fed Discount Rate by .25%. Within minutes of the Thursday afternoon Fed statement, many Wall Street traders, analysts and media representatives began to foretell of higher interest rates and lower stock markets. And indeed, the markets opened sharply lower Friday morning as the DOW futures suggested a decline of 70 points, but by noon most market indexes were up and largely remained that way for the remainder of the trading session.

Conventional wisdom suggests that rate increases spell trouble for the markets, so why not today? And how is it that early forecasts for lower equity values turned into a nine point gain on the DOW? Well, as it turns out, conventional wisdom isn’t all that conventional or wise; and most people don’t understand the relationship between the Federal Reserve and interest rates well enough to see how a change in the Fed’s discount rate impacts the market. Thank goodness for level headed economists.

The Fed Discount rate is not a market interest rate. Rather, it’s the rate the Fed charges banks wishing to borrow directly from the Federal Reserve; the lender of last resort. The discount rate had been set at .5% and member-bank borrowing was holding at just over $15 billion; compared to nearly $13 trillion of liquidity being held in domestic banking and capital market accounts. The .25% increase amounts to a very small drop in a very large bucket, and by the time traders and investors were able to digest the news and get past some of the initial excitement, the realization set in that the event was neither unexpected nor troublesome; quite the opposite.

Fed Chairman Bernanke has stated for some time that US monetary policy will need to tighten as the economy improves. Though tightening may manifest itself in many ways, the most common result is higher interest rates; whether through the Fed’s purchase (or sale) of bonds, increased reserve requirements imposed on member banks, or federal fiat. Even though the Fed’s decision to increase the discount rate is one of the least impactful on market interest rates, it’s evidence that higher rates will be in our future; just not right now.

Higher rates equate to a stronger dollar; as evidenced in declines in the price of oil and gold in early trading. But by the end of the session, both commodities had rallied along with the DOW. The bond market experienced similar activity.

So if the Fed’s action doesn’t necessarily signal a near-term increase in market rates, then what does it represent? Simply that Bernanke and the Fed Board of Governors see an end to the risk trade, an improvement in liquidity of member banks, and an overall strengthening in the US and global economies. Following the PIGS (Portugal, Italy, Greece and Spain) sovereign debt concerns of recent weeks, that’s excellent news. The Fed’s monetary policy staff, which includes some of the smartest economic analysts any of us will ever encounter, doesn’t make such decisions casually; especially in an election year with unemployment near 10%.

Market interest rate increases will most likely begin to appear late in 2010 and the Federal Reserve will probably put off increases in the Fed Funds Rate until after the mid-term election; possibly as late as early 2011. The employment and real estate markets both need the added support of low rates and a not-too-strong US dollar. In the mean time, expect the Fed to continue to moderate its support of the mortgage market and member banks; fewer of which are in need of Fed capital.


THE ECONOMY - Inflation’s Simply Not on the Horizon

One of the most consistent concerns expressed during the last year has been over possible inflation brought on by the substantial increase in federal spending and increases in the M1 and M2 money supplies. Gold Bugs have used the concern as a means of pushing the commodity’s price higher; political conservatives have used it as a stick with which to beat the Obama administration, though with little merit; and some of those on fixed incomes have begun to scale back their lifestyles to adjust to pending price increases. But there’s simply no empirical evidence to support the current fears. Which is either a Good News/Bad News tale, or possibly Bad News/Bad News; allow me to explain.

The CPI (consumer price index) data released this morning by the US Department of Labor’s Bureau of Labor Statistics reflected a .1% decrease in core price levels for the first time in twenty-seven years. When compared to similar data from the past 12 months we see that core prices have slowed their rate of increase from monthly rates of less than .3% to the recent .1% decline. The movement has not coincidentally followed the decline in US employment rates; which relationship will become important as we move on.

Core price levels don’t include energy and food items and shouldn’t be viewed in isolation. But even when the CPI is expanded to include all items, the annual rate of increase is barely 2.6%; not exactly representative of hyper inflation.

Persistent inflation can only occur when personal income levels increase sufficiently to put enough additional buying power into the hands of consumers and encourage them to seek after greater quantities of goods and services; pushing prices higher. Even though personal income levels increased slightly in 2009, and are likely to do so again in 2010, the increases aren’t enough to significantly raise prices. As long as we’re dealing with high levels of unemployment and a limited wage/price relation, broad-based inflation can’t reasonably gain hold of the economy.

Most policy makers, notably labor economists, have come to realize that persistent inflation has become meaningfully more difficult to experience than in decades past. Many of us recall the inflation and stagflation periods on the 1970’s and 1980’s, but don’t realize how much of that was a product of the strength of labor unions and collective bargaining contracts. These cooperatives have substantially less power today than they did during the latter half of the 20th century; consequently, wage increases for the foreseeable future will remain modest.

Many of the personal income increases hourly wage earners experienced up through the 1980’s were the result of labor productivity gains; as such, employers were motivated to pass some of the gains on to workers. But since the early 1990’s, most productivity increases have been brought about by technology gains requiring large capital investment by business owners and shareholders; not by improvements in labor. In many cases these gains have decreased the need for skilled workers and rather than bringing about increased incomes for wage earners, they’ve been more likely to provide returns for investors, business owners and corporate executives; otherwise these groups would have limited incentive to innovate and invest.

So what’s the Good News/Bad News tale? The much feared inflation scenario simply isn’t on the horizon; due in large part to employment levels that are likely to be persistently lower and personal income increases for hourly-wage earners that are likely to be nominal. And the Bad News/Bad News possibility? Across-the-board tax increases are nearly inevitable, and are likely to put additional pressure on household discretionary income; which could serve to slow price increases even further and make it that much more difficult for a return to a robust employment market.

There are solutions to all of this, of course, and they include improvements in education, technology and the capital markets. And we’ll discuss these further over the next several issues of Signature Update.




Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC