Your Economy (No Politics)

[Bullwinkle]

Fed Locked in by Prior Policy Errors
Comstock Partners, Inc.
Thursday, April 20, 2006


The “one and done” crowd is at it again. They ignited a sharp market rally by focusing on a single sentence in the March FOMC minutes that stated: “Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the danger of tightening too much.” A closer reading of the minutes, however, reveals a much more balanced view than the one sentence taken out of context. The statement also said that the labor market was tightening, that output was close to potential and expected to remain so, that core PCE inflation was expected to move slightly higher in 2006, and that the elevated prices of energy and other commodities could add further to inflationary pressures.

This is the fourth or fifth time since October that the market has rallied based on the last Fed rate hike being near. We don’t dispute the idea that a May rate increase may be the last, provided that the economy shows some signs of softening and the housing market continues to cool. As we pointed out in prior comments, however, we disagree that the end of rate hikes are generally followed by a strong stock market. In the last 12 periods of rate hikes the market declined 10 times following the last increase with the average decline amounting to 22% over the next 10 months. A recession followed in 9 of these cases with the economy peaking 4 months after the last increase.

We also disagree with the inordinate faith the market puts in the ability of the Fed to forecast the economy or even to understand what the economy is really doing at any given time. In this regard the recently released transcripts of the FOMC meetings in 2000 reveal that throughout most of the year the Fed had no idea that the unraveling of the dot-com boom would throw the economy into recession and that the market was about to fall apart. To make up for these errors and prevent a complete collapse, the Fed proceeded to lower rates to 1% and keep them there long enough to generate the housing boom that revived the economy at the expense of a massive trade deficit, a negative consumer savings rate and record consumer debt.

Now the economy faces an even greater danger from the potential unraveling of the housing boom that has been by far the most important factor keeping the economy afloat for the last four years. That the housing market is definitely softening is indicated by housing starts, permits, homebuilder surveys, buyer affordability, lagging sales and burgeoning inventories of both new and existing homes. The housing sector has provided a large part of the increase in employment over the last few years while mortgage equity extraction has been an important contributor to consumer spending. Without the impetus from housing both consumer spending and employment is likely to weaken.

If the Fed is looking closely at the housing market, they will most likely stop raising rates soon. It’s a tricky call, however, as it would be highly unusual to stop increasing rates while gold prices are soaring and key commodities are making multi-year highs. Whatever the Fed does, in our view a damaging recession and a continuation of the secular bear market is baked in the cake.

http://www.comstockfunds.com/index.cfm/act/newsletter.cfm/CFID/3100225/CFTOKEN/15616716/category/Mar...