Your Economy (No Politics)

[Bullwinkle]

A Fork In The Road
Comstock Partners, Inc.
Thursday, July 20, 2006


Every time Ben Bernanke speaks or writes the market either soars or plummets despite the fact that his message has essentially been the same since he took office. It seems to us, from a detailed perusal of his statements, that the central banker has been saying all along that the lengthy period of assured measured rate hikes is over, and that from here on the Fed would set future policy in accordance with the incoming data. He never said that the FOMC would pause. Nor did he say that they would hike rates indefinitely.

Writing today about Bernanke’s Congressional testimony, the Wall Street Journal headline said, “Bernanke Expects Slowing Inflation to Tame Economy”, while the New YorkTimes stated, “Fed Chief Optimistic On Inflation”. This is certainly not new as the FOMC June 29 statement said virtually the same thing three weeks ago. In addition, today’s release of that meeting’s minutes indicates that the FOMC was highly concerned about increasing inflation as well as the softening economy that reflects the dilemma the Committee is facing as they decide what to do at future meetings.

This is about the sixth time since last October that the market has rallied sharply on the thesis that the round of Fed rate hikes is coming to an end. For some puzzling reason, both the Street and the media automatically assume that stocks soar after the final increase following a series of rate hikes. Nothing could be further from the truth. In the last 53 years there have been 12 periods where then Fed has engaged in a series of rate increases. In 10 of these instances the S&P 500 declined AFTER the final rate increase, with an average drop of 22% to the eventual bottom. On average the market bottom occurred 10 months after the end of tightening. Importantly, an economic recession followed in 9 of the 12 cases. On average, the peak of the economic cycle took place four months after the last rate increase, although in two instances the peak actually occurred first, meaning that the last tightening was implemented after the recession started, but before the Fed was even aware of it.

The problem for the Fed is that the lead time between rising rates and their impact on the economy is fairly long, and that once the Fed sees an actual softening in the economy, it is usually too late to prevent the most recent rate hikes from taking the economy from mere softness to recession. At the same time, inflation is a lagging indicator that usually appears most threatening at the same time the economy is already showing signs of weakness.

That is precisely the dilemma the Fed faces today as inflation threatens to get worse while the economy is slowing. The Fed has just now come upon the "fork in the road" and as Yogi Berra said profoundly, "when you reach a fork in the road --you take it." On an annualized 3-month basis core CPI in June has risen 3.6% compared to 2.0% in February. CPI core services has climbed 4.5% from 3.0% in February. Potential inflation in the pipeline looks even worse. Year-over-year PPI core intermediate goods were up 7.2% against 4.5% in March, with the 2nd quarter up 9.8% on an annualized basis. PPI core crude goods have soared 33.7% year-over-year, with the second quarter up an alarming 63.1% annualized.

At the same time developing economic weakness is evident in the NFIB small business index, the Conference Board business confidence survey, the U. Mich. Consumer confidence survey, the NAHB housing index, the housing affordability index, the Conference Board leading indicators, retail sales and real disposable income. The Fed has therefore come to a fork in the road where they have to decide which is the worst threat—potential inflation or the possibility of recession. Knowing that the economy has already softened and that the last two or three rate increases have yet to kick in, the Fed may well decide to end its cycle of rate increases at either of the next two meetings.

Whatever they do, however, the outcome is most likely baked in the cake as a result of past decisions. The 425 basis point rise in the fed funds rate, the inverted yield curve and the 0.6% drop in the leading indicators over the last six months all indicate the strong probability of an upcoming bear market and recession. In our view the impending end to the series of Fed rate hikes is nothing to cheer about.

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