01 Sep 2006 Is the Fed Listening to the Markets?
Three weeks after the Federal Reserve ceased its 17th straight quarter point interest rate hikes debate continues as to whether they are finished, even among Fed officials. Minutes released from their latest meeting reveal that members expect core inflation “to decline gradually” and that pausing was a “close call.” Many believe that more increases may well be needed even while saying “the full effect of previous increases in interest rates on [economic] activity and prices probably had not yet been felt, and a pause was viewed as appropriate to limit the risks of tightening too much.”
The Wall Street Journal notes that financial markets currently believe that slowing growth will help moderate inflation, and that the Fed will hold monetary policy steady for some time as a result. But Fed officials continue to fan the possibility of further increases. Federal Reserve Bank of Dallas President Richard Fisher said Wednesday inflation has been running higher than he’d like to see, and said the central bank must make sure price pressure remained contained. But he added that “it was the collective judgment of the committee that we were at a juncture where it made sense to evaluate the lagged effect of these [rate increases], especially on the inflationary impetus of the economy.” So they will continue to monitor the data for direction.
The Conference Board released its consumer confidence results for August this past Tuesday surprising most economists with its weakness. It fell from a revised 107.0 in July to a 99.6 for August; the lowest since the 98.3 seen in November 2005, providing further evidence that growth of the economy is slowing.
The Commerce Department reported on Wednesday that the economy grew at an inflation-adjusted annual rate of 2.9% in the second quarter, revised upward from an earlier 2.5% estimate but considerably slower than the 5.6% pace in the first quarter.
Despite the weakening housing market and volatile energy prices, many experts expect economic growth to continue along a stable path similar to the second quarter’s slower pace, according to the WSJ.
But the slowdown will exert pressures throughout the economy. Corporate profit margins will likely fall as labor costs rise. The Commerce Department’s report showed that wages and other employee compensation had been sharply raised for the first half of the year. The development could mean good news for consumer spending, but difficulty for corporations and their profit margins, especially at a time when productivity growth is slowing.
As to portfolio strategy: Over the past several months we have moved toward a more conservative posture in all of our portfolios. We have added to our bond holdings in all models and lengthened maturities as we expect interest rates to fall over the coming year. In May we greatly reduced our emerging market exposure in our growth accounts, and eliminated it in our more conservative accounts. Finally, we continue to focus more on value (typically dividend-paying) stocks than growth stocks. When it appears that the economy has reversed course and begun growing again and until the Fed is convinced that inflation is licked we will stay mostly clear of growth stocks.
The long bond (30 year) has been falling since May 15th. Bond investors (historically the best predictors) have been saying since May that inflation is not a problem. The stock market topped on the same day. Could it be that both markets are telling the Fed that rate increases are sufficient? After an 8% decline in the stock averages, stocks strongly reversed their downward spiral in late July. A string of strong earnings reports were enough to brighten investor’s hopes, at least for the short term. Technology companies have had the largest moves. Cisco is up 25% since August 9th on earnings and remarks by Chairman John Chambers that his company’s outlook is bright. If he is right, perhaps it means that companies are once again spending big on technology to further enhance productivity. While the Fed is in the driver’s seat, markets and corporate leaders seem to be counting on a soft landing of the economy followed by a recovery on its heels. We will watch carefully.