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August 9, 2002
Overall financial market psychology changed this week for the first time in two months, and the change tends to put a 6.25% floor under mortgage rates.
Stock marketeers this week talked themselves into believing that the Fed would begin to cut its 1.75% overnight Fed funds rate at its Tuesday, August 13, meeting. As this choir preached to itself, expectations rose: the Fed might cut a half-percent all at once. The funds rate would fall to 1.00% by year's end -- all this without the slightest smidgeon of leak or hint from the Fed itself.
Alan the Divine is going to Save Us! Stocks rose 9% during the week, their best weekly performance in fifteen years.
At the height of the prayer meeting, the normally non-believing bond market types were sucked in, too. The 10-year T-note traded as low as 4.21% in Monday's economic gloom, the lowest on any day since 1965, and soared to 4.43% by Wednesday. Bond market types do not want either stocks or the economy to be saved, and consider such pending eventualities as good reasons to sell the house.
Now, at week's end, it's hard to find anybody who still thinks the Fed will ease on Tuesday, and bonds and stocks sit in oddly opposed entrenchments. Bonds have sobered up, and the 10-year is back down to 4.26%, but stocks have held every dime of their miraculous resurrection. One of the two markets is mistaken.
Should the Fed ease? Will it?
Doesn't much matter. Unlike every other recession since the big one ('29-'38), the Fed didn't cause this down-cycle with high rates, and thus can't fix it with low ones. Nevertheless, most prognosticators have insisted for a year-and-a-half that Alan would Save Us.
From January '01 to September 10th, the Fed cut its rate from 6.50% to 3.50%. Surely that would cause a recovery, even the bond market ghouls believed. Mortgage rates stayed 6.75%-7.00%. From September 12th to December '01, the Fed cut from 3.50% to 1.75%. Surely that would cause a recovery. Mortgage rates actually rose into 2002, cresting 7.00%, and the stock market rallied nicely.
By June... well... the mini-recovery faded to nothing. Mortgages broke 35-year records following the stock market down.
So. What is a 1.00% Fed funds rate supposed to do that a 1.75% rate has not?
Central-banking theory is correct: for rate cuts to work by themselves, the cost of money must fall substantially below the inflation rate. There, the Fed has a problem: the inflation rate is 1.00% or less, and the Fed can't get under it enough to matter.
We are at the conclusion of a 21-year disinflation cycle, and the Fed has overshot. The producer price index (basically, wholesale prices) fell again in July, and has fallen 1.1% in the last twelve months -- only the third year-over-year decline on record, and the steepest in the thirty-year history of the index.
In the aggregate, American businesses cannot raise prices. The only way to increase net earnings is to cut costs, increase productivity, and innovate -- in the long run, an excellent condition. However, in the short run, too many businesses cutting costs at once, and seeing no reason to spend to expand, is dangerous.
Brad Bickham of Sargent Bickham brought charts today which show corporate profitability returning to healthy, no-foolin', 1998 levels. If he's right, and American businesses successfully tread water through this patch, then the stock market and mortgage rates have found bottom, and a slow-but-solid, real recovery is coming.
If corporate cost-cutting translates into frozen capital spending and job losses, we're not at the bottom of anything, and there's little the Fed can do about it.
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