Fear of Sustainable Growth

By Dr. Duru written for One-Twenty

June 6, 2006

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Once again the market hopped up and down as if it had stepped on a nail or two. "BERNANKE MAKES HAWKISH STATEMENTS!" blared many headlines. And so the markets sold off again...afraid the Fed would raise interest rates again. Clearly, everytime the Fed Chairman speaks at an event we need to buckle ourselves in tight.

Now, you faithful readers know I like to read things for myself, especially when it comes to the Fed. This time was no exception. When I first heard about Bernanke's "surprisingly" hawkish comments, I thought that this guy is surely trying to destablize the market! The market was clearly not prepared for what Bernanke had to say, and the timing seemed particularly unfortunate given that the market seemed to be finally stabilizing from May's correction. But then I realized that Bernanke did not say anything new and certainly nothing that the market did not already know (I have been amazed at how often the market chooses to react to old news. If this is a forward-looking, discounting mechanism, it sure is inefficient. Hmmmm....). Sure, the tone and the structure of the speech was a bit new, but we already saw the market convulse last month on the same heated inflation data that now Bernanke confirms he worries about: "...at annual rates, core inflation as measured by the consumer price index excluding food and energy prices was 3.2 percent over the past three months and 2.8 percent over the past six months. For core inflation based on the price index for personal consumption expenditures, the corresponding three-month and six-month figures are 3.0 percent and 2.3 percent. These are unwelcome developments."

So, if this is all old news what is the market fearing? The market is technically fearing that the Fed will overdo these rate hikes and kill the economy. So, we can think of these sell-offs as a partial no-confidence vote in the Fed's ability to achieve its objectives of price stability and sustainable growth. In fact, if you tried to take a literal read of the Fed's statement and juxtapose it with the market's disapproval, you would think that what the market really fears is sustainable growth! After all, Bernanke referenced the objective of sustainable growth four times in his speech. He sounds downright noble when he states "...a sustainable, non-inflationary expansion is likely to involve some moderation in the growth of economic activity to a rate more consistent with the expansion of the nationís underlying productive capacity." He just wants to cool things off so that we can continue to enjoy ourselves without worrying about rampant inflation. And for this, we tremble and cower in fear? Market madness, indeed!

One final note. When you read Bernanke's actual statement, you will see that the Fed believes it has successfully squashed speculation and rampant price appreciation in the housing market: "Overall, housing activity has softened relative to the high levels of last summer, and the rate of house-price appreciation appears to have lessened. A slowing of the real estate market will likely have the effect of restraining other forms of household spending as well, as homeowners no longer experience increases in the equity value of their homes at the rapid pace seen in recent years." Mission accomplished! This slowdown has occured without bringing the economy to its knees. So, of course the Fed feels emboldened to go after the high prices in commodities. Fortunately, Bernanke recognizes that some of the problem lies in supply constraints - "the increased world demand for crude oil and other primary commodities, together with the limited ability of suppliers to expand capacity in the short run, has led to substantial increases in the global prices of those goods" - but he will do what he can to take care that the demand side of the equation does not take these constraints to an inflationary boiling point.

So, do we fear the Fed will be successful and raise rates just enough to bring about sustainable growth? Do we fear that the Fed will not do enough and inflation will run out of control (I have argued before that the Fed will find itself raising rates longer than we or they expected)? Or do we fear the Fed will plain fail altogether and leads us into another financial calamity? There is plenty of uncertainty here, and that uncertainty is driving the wild volatility in the market. It is like I said in an earlier missive, this volatility is going to make it extremely difficult to hold onto equities for some time to come. The again, this is probably just what Big Ben wants: "Although market participants appear to have become more attuned to risks in recent weeks, corporate bond spreads remain low, and banks are well capitalized and willing to lend." In other words, there is still plenty of work to do to get the market to price in risks properly. Brace yourselves...

And be careful out there...!

© DrDuru, 2006