Your Economy (No Politics)

[Bullwinkle]

A Tempest in a Teapot
Comstock Partners, Inc.
Thursday, December 15, 2005


The FOMC statement following last Tuesday’s meeting did not constitute any change in policy. Neither did it change the eventual upside fed funds target for the simple reason that no such target existed. All the Fed did was to eliminate the language that painted them into a corner that would have made it awkward to stop raising rates with no warning. How much longer the Fed continues to hike rates and to what extent still depends on the incoming data as it always has, no matter what the prior statements indicated.

Past FOMC statements could be broken down into three main provisions aside from the rate decision itself. The first was a statement of their views on the growth of the economy and the rate of inflation. The second was a statement of the upside and downside risks of the attainment of both stable growth and price stability. The third was a statement that the current policy was accommodative and that the accommodation would be removed at a measured pace. This was the policy that would presumably keep the risks in balance.

Now let’s take a look at the changes in Tuesday’s statement. The assessment of the economy and inflation actually sound somewhat more hawkish than the November release, which mentioned temporarily depressed output and employment as a result of higher energy prices and hurricane activity. The current report asserts that despite the energy situation and hurricanes, economic activity appears solid. This is definitely a stronger statement of economic growth. In addition the December release points out “possible increases in resource utilization” (read employment and capacity utilization). This feature was not in prior Fed statements and indicates a somewhat increased concern about potential inflation.

The two previous provisions of risk assessment and policy accommodation were basically combined in the current report. The main change was that the prior reference to policy accommodation was left out. In our view this did not constitute a change in current or prospective policy, but was merely a bow to reality. After all, following 13 rate changes in 18 months to a level almost equal to the 10-year note how could the FOMC still maintain that they were accommodative without losing their credibility? It’s significant that despite dropping the “accommodation” word, the Committee still stated that “further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance”.

Notice that in the November statement, it was the measured removal of accommodation that would keep the risks in balance. Now, however, while they are no longer accommodative they still need further policy firming to accomplish the same objective. If the Fed is no longer accommodative, but is still likely to hike rates, then they are obviously telling us they will get restrictive if they find it necessary. Whatever policy the Fed eventually follows will not be changed one iota by elimination of one word from the statement.

All in all, the whole exercise of slicing and dicing every word in FOMC statements is futile. The Fed itself doesn’t know what they will do at future meetings and neither does anybody else. Essentially, the Fed will follow the data as has always been the case no matter what any previous statements have said. In our view the Fed still faces a serious dilemma in trying to walk a tightrope between economic growth and inflation. Any serious downturn in home prices or even the lack of further increases could kill the golden goose that supports U.S. consumer spending and the entire global economy. On the other hand, a continuation of the boom would stimulate the migration of high energy prices into a wide array of goods and services making even more restrictive monetary policy necessary down the road.

In our view the peak in housing has already occurred, and the slowdown will spread to consumer spending and the rest of the economy. Depending on how fast this happens, the Fed may very well stop tightening after the next meeting or two, but it won’t be as a result of the current statement. It will be a result of increasing economic softness that leads to disappointing corporate earnings, an event for which a highly overvalued stock market is totally unprepared. The end of the rate rises will therefore not be greeted by a relieved stock market, but by a market focused more on the prospects of a sluggish economy and disappointing earnings.

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