Bernanke's Cloudy Crystal Ball Comstock Partners, Inc. Thursday, April 27, 2006
Although Chairman Bernanke gave the market what it wanted to hear—that the Fed may soon pause in its series of rate hikes—his testimony before Congress also hinted at the dilemma the central bank still faces. The economy is looking at two key factors with long and uncertain lead times, each pulling in opposite directions.
The 15 consecutive rate increases since June 2004 are finally beginning to slow down the housing market, and the lagged effect of the tightening process combined with higher energy prices should slow the economy even more in the months ahead with recession a distinctly possible outcome. As recent Fed statements and speeches indicate, the FOMC is concerned that they may tighten too much. Bernanke seems particularly concerned about the housing industry as well he should. Despite the higher March numbers, both new and existing home sales are in a declining trend with inventories rising strongly. Since last summer the mortgage purchase index is down 26% and REFIs down 50%. Today both CTX and Pulte announced that their orders were down 11% year-over-year while Beazer’s orders were down 19%.
At the same time inflationary indicators also appear threatening as is indicated by rising prices for energy, gold and industrial commodities. Although so far these increases have not crept into the general price level to any great extent, this is always a possibility if the Fed takes its foot off the brake too soon. Historically we don’t know of any instance where the Fed stopped raising rates with oil, gold and basic industrial commodities at multi-year highs as they are today.
Thus the Fed is faced with the possibility that anything it does now may turn out to be wrong. Keep hiking rates, and the economy can go into recession. With varying and uncertain lead times, even the rate increases that have already taken place may have gone too far. On the other hand stopping the rate hikes too soon may allow inflation to take hold, making it that much harder to stop after a pause.
The Fed apparently recognizes these difficulties, and that is why it most likely will pause and watch the incoming data. If the economy then proceeds to slow down, no further rate rises will be necessary. However, if the economy continues to grow above its long term trend and prices begin to soar, the pause will be just that, and additional rate increases will be forthcoming. Therefore Bernanke’s testimony, rather than being a decisive call on future FOMC action, is more an admission that their crystal ball is so cloudy at this point that they don’t know what the incoming data will show. It is indeed ironic that the Fed with some 225 economists—almost all of them with PHDs—is forced to sit and await the incoming data just like the rest of us.
In our view Bernanke’s testimony doesn’t change anything for the market. As we have previously pointed out, 10 of the last 12 monetary tightening periods have been followed by bear markets, and 9 by recessions. If the economy slows after the Fed rate hike pause, it is probable that recession and a bear market will follow. On the other hand, if the economy continues to expand above trendline, the Fed would only have to resume hiking rates with the same results highly likely.
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