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Harry Koza's Weekly Column

Fed ought to be concerned about inflation -- after all, it caused it

It's the New Year, and I was back in front of my screens this week still suffused with holiday torpor. The bond market was looking lethargic as well; with school not starting until Jan. 8, many participants are still hanging out with their kids. So it was looking like pretty thin gruel ahead of today's employment report for your faithful bond market analyst/reporter/whatever. Not to worry, though, because on Wednesday the U.S. Federal Reserve Board's Federal Open Market Committee (FOMC) released the minutes of their December meeting.

These minutes are usually much more interesting than the laconic boilerplate of rate announcements. Two things stood out. First, the FOMC members displayed an alarming new sensitivity over the "substantial cooling" of the U.S. housing market, and are worried about the "considerable uncertainty regarding the ultimate extent of the housing market correction." That's sort of like the Fed-speak equivalent of an air traffic controller screaming at a pilot, "Pull up, pull up!" as a 747 corkscrews into the tarmac.

The other main theme of the minutes was the committee's "predominant concern" that inflation would not "moderate as desired."

Well, Fed policy makers ought to be concerned about inflation, because they caused it. Cast your memory back to the tech wreck in 2000, followed by the corporate recession in 2001, then 9/11 and its subsequent economic effects. The U.S. economy was looking like it was turning Japanese, which gave the Fed the willies, making everybody tip-toe around carefully not saying the D-word (deflation).

No problem, just give the old economy the usual Keynesian kick-start: Tax cuts in 2001, crank up the money supply, lower interest rates, boost military spending (there's a reason there's at least one U.S. military establishment in just about every congressional district), and the easiest to achieve, getting government to run huge deficits.

Oh-oh, it didn't work. By 2003, the U.S. economy was still shuddering along like a high-mileage Lada with a blown cylinder, and the Fed Heads were worried about the possible occurrence of the dreaded double-dip recession. Things were in danger of turning even more Japanese (I really think so). In November, 2002, Ben Bernanke, not yet Fed chairman, gave his famous helicopter speech, saying Japanese-style deflation could never happen in the United States because the Fed could always drop billions of Ben Franklins from helicopters (We've got a printing press, and we ain't afraid to use it!). He was kidding, wasn't he?

Still, being a government organization, the Fed couldn't help itself. If what it was doing to stimulate the economy was not working, well, they'd just have to do a bunch more of it. They cut interest rates from an already low 1.75 per cent down to just 1 per cent, and then left them there for a full year, an unprecedented occurrence.

That had the desired effect. It put the kibosh on the D's --deflation and the double-dip (that's not a bad name for a rock band, by the way).

Money was cheap, sparking economic activity, and gross domestic product grew nicely. Anything priced in dollars -- gold, oil, Picassos, stock markets -- went up in price. Consumers used cheap debt to buy houses, Hummers and huge HDTVs. Sales of houses and cars especially -- things normally financed with debt anyway -- skyrocketed. Loans were so cheap it didn't matter how much a house cost, and anyway you could easily get a cheap mortgage for 100 or even 120 per cent of the cost, with interest only or even a reduced interest rate for the first few years. And no pesky credit check necessary, either.

All that cash chasing houses (and the plasma TVs and granite counters to put in them, not to mention the SUVs in the driveway) inevitably caused inflationary pressure -- and inflation, as Milton Friedman liked to point out, is always and forever a monetary phenomenon.

So the Fed started raising rates. By this time China had obligingly stepped up to the plate, selling the United States the apparel, running shoes, furniture, manufactured and durable goods that the debt-fuelled spending spree demanded. Even more obligingly, they parked a trillion bucks worth of the proceeds in U.S. Treasury securities, helping keep effective interest rates low even while the Fed was raising official rates.

That brings us to today. The U.S. housing market is slowing down. From 2001 to 2005, it accounted for more than 40 per cent of the country's job creation. The number of realtors alone, as a percentage of the total U.S. labour force, increased by almost 50 per cent. But as the Fed started raising rates (since June, 2004), real estate job creation has dropped by 68 per cent. With fewer folks working, who's gonna buy all those houses? More importantly, who's gonna buy that second house you planned to flip in a month when you bought it nine months ago?

Meanwhile, the consumer -- whose spending accounts for an astounding 70 per cent of the U.S. economy -- may not be busted but he is certainly badly bent.

All those exotic mortgages are turning out to be not so much fun. (They aren't much fun for the mortgage lenders, either.) I've been collecting scary statistics on the housing bubble for a while now, but I'm running out of column here so I'll have to save them for next week.

In anticipation of that, let me leave you with a timely restatement of Harry's Second Law of Capital Markets: Never be long two houses.

Harry Koza,

Sr. Market Analyst,

Thomson Financial,

36 Green Meadow Crescent,

Richmond Hill, Ontario,

L4E 3W7

905-773-0328

harry.koza@thomson.com

hkoza@aci.on.ca



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