Your Main Guide for the Current Fed Cycle

By Dr. Duru written for One-Twenty

November 17, 2006

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Earlier today, SeekingAlpha posted a very good article by Chris Ciovacco titled "Use Common Sense To Decipher Fed Comments." I think of it as the main guide I need for tracking and understanding the Fed for this current rate cycle. Chris notes that the long-term path to higher inflation is all clear now that the Fed is stuck tolerating more inflation than they prefer out of fear of completely killing the housing market. For example, the Fed continues to tell us that inflation remains a risk, yet, it sits by and does nothing now. The Fed is back to jawboning because its range of options is quite limited - even as credit levels in the economy continue to expand at a blistering rate. If have written before that we have created an economy that is addicted to credit, and, for whatever reason, that dependency has gotten steeper in recent years. Note how long it took the economy to finally get moving after the Fed started lowering rates. The Fed had to go to 1% before it felt it could stop and soon reverse course. Now, the momentum created by those record levels of easy money has allowed the economy to hum along and essentially ignore the last (and extended) rate hike cycle. In other words, money is still cheap, and the Fed would have to tighten a lot more to truly choke off the easy flow of credit in the current economy.

Something has changed in the financial markets. We used to hear "don't fight the Fed." This means that when the Fed drops rates, you buy stocks, and when the Fed increases rates, you sell stocks. Well, the stock market fell for another 18 months or so after the Fed started dropping rates in 2001. The Fed increased rates for over two years, and the market continued on an upward trajectory. We have unemployment levels back near historic lows and yet the housing market is falling off a cliff. Oil prices skyrocketed for over three years and yet consumers barely noticed and kept on ringing up the register and fattening the credit balances. This is what I suppose is the "new" bubble economy. We have seen one financial asset after another soar in price only to meet a brick wall and crumble back to earth as if the whole run-up was a fairytale. A friend of mine has tried to convince me that these successive waves of bubbles are good because they create over-investment at the expense of venture and specualtive capital that eventually leads the way to cheap infrastructure and an abundance of new goods and services that benefit the economy as a whole. I believe we saw that with the dotcom bust: it delivered a lot of fiber optic cabling that remains under-utilized (at least last time I checked a few years ago!). The railroad boom and bust of the 1800s led to an era of cheap and widely available long-haul transportation in the United States. In a simialr vein, Chris notes that periods of hyperinflation (think bubbles) eventually lead to deflation (think the crash). The actions of the Fed, as opposed to its words, indicate it fears deflation more than it does hyperinflation, so the bias in the economy will be towards more inflation.

This week's inflation data led to some relief that inflation is no longer a problem. But we know that this data must be transient unless of course the economy is truly transitioning toward recession. But if such a slowdown occurs, the market has already bet that the Fed will step in with rate cuts. And if the Fed delivers, then our next support for more inflation will be in place. In the meantime, I still suspect that the Fed is looking for at least one more excuse to raise rates to attempt to prove to the market that it is serious about fighting inflation. It is not done being done just yet...

On a side note, I hope to have a review of my claims and predictions over the last few months. I have nailed some good ones, but my understanding (and appreciation) of this amazing rally was a bit askew!

Be careful out there!
DrDuru, 2006