23 Sep 2005 Damn the Hurricanes, All Ahead “Measured Pace”
If they were considering a pause in their relentless rate increases the Federal Reserve Governors missed a great opportunity to both assess the effectiveness of past increases as well as to show a little social empathy. They called Hurricane Katrina’s economic disruption only temporary and made no mention of the potential economic cost of Hurricane Rita as it raced toward the heart of the nation’s oil, gas, and gasoline production facilities. Instead of pausing they raised the federal funds rate by a quarter percentage point to 3.75%. The increase marked the 11th time since June 2004 and the longest sustained tightening campaign since 1977-79, when the Fed was fighting runaway inflation.
The Wall Street Journal pointed out that after Katrina many observers wanted the Fed to stop and assess the storm’s long-term economic damage, but they went ahead anyway saying Katrina’s effects “do not pose a more persistent threat.” “We shouldn’t be surprised if the Fed has misjudged,” David Resler, chief economist at Nomura Securities International, told clients, “just as it has done in each of the three previous tightening cycles during Mr. Greenspan’s tenure.” And back in 2000-2001 many investors, including me, learned all over again just how painful it can be to fight the Fed or to assume they will cease tightening before damaging the economy.
But there is slight hope that this time may be different. In a rare dissent, Fed governor Mark Olson voted against the rate increase, his only dissent ever and the first since 2003. Historically members vote unanimously with the Chairman. And according to the WSJ only seven of the Fed’s 12 districts asked for an increase in the symbolic discount rate; in the prior three meetings, that request was unanimous. Rest assured though, we will err on the side of caution. We believe Mr. Greenspan will risk growth in the economy, even a slowdown, to control inflation.
Over the past month the best performing sectors have been energy and natural resources. The MSCI Brazil Index is up an amazing 22% with surprising balance in their economy, not just petroleum. The larger S&P Latin American 40 Index is up 15%. The worst performing groups have been consumer discretionary, retailers, food and beverage, and consumer staples.
Interest rates have generally risen across the board during the month of September. At the short end they are up a quarter percent to 3.97%. The recent peak in the two-year Treasury was in early August when that yield reached 4.16%. The 10 and 30-year Treasuries are up a quarter percent as well. The yield curve, the spread between short and long term maturities has been rising steadily throughout the month of September. The spread has been an historically important measure of the ability of banks to lend money profitably. They are discouraged from lending when the yield cure is negative so capital for business dries up. However, in recent years significantly other capital sources have become available to corporations, making the measure less predictive of future economic growth.
We believe the US economy can sustain its growth in spite of damage from major hurricanes and the commensurate higher fuel prices. However, the Federal Reserve with their inflation concerns, short-term or long-term, real or feared, will be the determining factor in this economy enduring health. Productivity increases have carried the load for this entire recovery. Whether they can continue to do so is critical. We’ll keep watch.