Your Economy (No Politics)

[Bullwinkle]

The Tipping Point
Comstock Partners, Inc.
Thursday, May 18, 2006


The difference between the actual April increase in the core CPI and the forecast was a mere 0.1%, but proved to be the tipping point that exposed the Fed’s dilemma for all to see. The three-month annualized average of core CPI is now running at 3.2%, well above the Fed’s preferred upper limit of 2%. Since inflation is a lagging indicator, and the Fed is forecasting an economic slowdown that would presumably moderate future price increases, the FOMC would love to take a pause in hiking rates at their June meeting, and await more economic data. They are also fully aware that the central bank has historically not stopped their series of rate increase soon enough to avert recession, and they would like to get it right this time around.

Unfortunately, however, there are other key considerations that argue against this. First, the Fed forecast of a slowdown could be wrong, in which case inflation could jump, and then be that much harder to control. Memories of the super inflation of the 1970s are still vivid, and even inflation doves don’t want to get into that mess again. Second, even if the Fed’s forecast of an economic slowdown proves to be correct, a June pause in the rate hikes before such a slowdown is evident could ignite Inflationary expectations even further. Just as the Fed is aware that they can go too far in raising rates, they are also aware that inflationary expectations can themselves feed inflation. In a speech given today, St. Louis Fed President Poole stated that the risks on inflation are tilted to the upside and that he pays a great deal of attention to inflation expectations. He added that incoming data rather than forecasts would be the key to future FOMC decisions. In another speech, Richmond Fed President Lacker said that “The inflation outlook is on the border of unacceptable and perhaps moving beyond…In circumstance like that, containing inflation has to be the primary focus.”

The Fed therefore is stuck between a rock and a hard place. On the one side is evidence that the economy is already softening or about to do so shortly. This is indicated by the softening in housing, lackluster payroll growth, sluggish retail sales and lower consumer confidence. To this we can add the lagged effects of a 400 basis point rise in short rates and the elevated level of energy prices, both of which have signaled economic downturns in the past. On the other side are the rising inflationary pressures from the core CPI (which is likely understated), the weak dollar, higher energy prices, the boom in industrial commodities and relatively strong production growth.

As we have long believed, there is no easy way out of this situation. Investors are rooting for a pause on the misconception that stocks soar after the Fed stops hiking rates. As we have shown in previous comments, the market usually declines substantially after the final rate increase On the other hand, talk about a pause worries the inflation hawks who believe that if the Fed stops too soon, inflation can get out of hand. All of this is taking place in an exceedingly fragile macro environment featuring a record trade imbalance, big budget deficits, record household debt and a negative consumer savings rate.

Belatedly, the market has now taken notice of the dilemma. The S&P 500 has decisively fallen out of its narrow six-month uptrend while the key Nasdaq 100 peaked back on January 11, and has already declined near 10%. Market internals such as breadth and the number of daily new highs and lows have been looking shaky for some time. We believe that a tipping point has now been reached and that the cyclical trend has changed from bullish to bearish. While numerous rallies are likely, in our view the overall decline will be substantial.

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