February 2007
The "Catch"
The Labor Department reported that its Consumer Price Index (CPI) rose a higher than expected 0.2% in January. More surprisingly, the core CPI – less food and energy – rose by 0.3%, pushing the year-over-year core rate to 2.7% and much higher than the Fed’s comfort range of 2.0% - 2.25%. The surge in core inflation during January resulted primarily from higher health care, food and tobacco costs. The rise of these three components more than offset a 3.1% decline in energy prices during the month. Energy prices have since returned to an upward trend.
In a separate report, a new federal study projects U.S. health care spending will double to $4.1 trillion by 2016 representing 20% of Gross Domestic Product (GDP). Currently, health care spending accounts for 16% of GDP. The study also points out that the government currently picks up about 45% of the health care spending, but by 2016 Uncle Sam will be footing about half of the bill. Without health care reform of some sort, costs are likely to continue to put increasing pressure on the Consumer Price Index for the foreseeable future.
The stock market has been surprisingly strong since mid-2006 on the back of healthy corporate earnings and a stabilization of interest rates. Corporations have been able to reduce costs via job reductions, mergers, acquisitions, and moving manufacturing abroad and this has enabled them to keep pace with Wall Street’s earnings expectations. At present, markets appear fairly priced based on historical measures and so the markets remain poised for profit-taking and a market adjustment on any indication of further economic slowing or on the fear of an increase in interest rates. In reviewing the minutes from the latest FOMC meeting, “All members agreed that the predominant concern remained the risk that inflation would fail to moderate as desired.” Much of the Fed’s beliefs for a cooling off of inflationary pressures in coming months are based on moderating prices for energy, commodities and housing prices. We agree with the latter, however, with developing and emerging markets coming into their own, the higher trend of energy and commodity prices appear stubbornly intact. A further downturn in the housing market, say in early Spring when unsold homes are reentered onto the market on top of an already bloated housing inventory, and in particular, the glut of dubious loans going bad (i.e., sub-prime loan market) will have a noticeable impact on the whole of the economy. Rising interest rates will only exacerbate the problem.
The “catch” is that if the Fed raises interest rates too much in order to support the dollar in foreign exchange markets, it faces the likelihood of recession at home. On the other hand, if the Fed holds interest rates steady or even lowers rates, should the economy warrant, it risks further declines in the dollar and, subsequently, the much needed foreign central bank demand for dollar-denominated IOUs. This is the classic quandary one faces with fiat currencies. Recession may come about either way. And then, the question will arise: Can the Fed spend its way out of recession this time?
Investors should keep in mind that economists point to “strength in consumer spending” while making bullish forecasts for this year and next. However, the consumer is usually one of the last to adjust to economic reality, having gotten use to a certain level of comfort and spending style. On the other hand, capital spending by business is beginning to show signs of slowing – typically, a leading indicator for economic growth. Additionally, the housing market, being in the midst of retreat and awaiting another round of selling in spring will likely lead to a slowdown in durable goods orders from the rapid 15% pace recorded in Q4 of 2006.
One recent bright spot… Reuters reported that recent Federal Reserve data showed that foreign central banks were net buyers of $8.29 billion of Treasury debt for the week ended February 21st. The Fed said its Treasury debt holdings (65% of total holdings) and its agency debt holdings (at 35% of total holdings) kept for overseas central banks rose by $11.83 billion to stand at a total of $1.828 trillion. As large dollar-denominated debt holders, foreign central banks also have an interest in slowing the dollar’s descent vis-à-vis their own currencies.
In the end, market forces will dictate rates to where demand meets supply. As always, the Fed will be forced to follow the market. We believe that slowing the dollar’s descent in foreign exchange markets will remain a primary focus for the Federal Reserve in the period ahead. The risks then are to the economy.