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June 13, 2008
The credit markets have concluded that inflation risk now forces the Fed into a sustained series of increases in its overnight rate, presently 2.00%.
Interest rates -- all of them -- spiked in the last 10 days. Lowest-fee 30-year mortgages to 6.625% (if you’re a shady character, FICO under 720, make that 6.75%), 10-year T-notes to 4.20%, and Fed-tied 2-year T-notes to 2.90% (+.55% this week).
The credit markets jumped to Fed conclusions after oil hit $135, ECB chairman Trichet indicated a tilt to tighten there, a string of inflation-centered speeches by Fed officials, and a rebate-bloated 1% pop in May retail sales.
It is folly to quarrel with a market move like this, but that’s what I’m going to do.
Think of the very first game of rock-paper-scissors, players uncertain whether scissors would cut paper, or paper would hide them; scissors would break on a rock, but not if stabbing the hand holding the rock. Which beats what?
In the last bad oil/inflation/housing wreck, 1979-82, the Fed did tighten (prime to 22%) into a contracting economy (unemployment to 11%), into the worst housing recession since the ‘30s (mortgages 18%), and into the insolvency of the S&L system -- all to break inflation running at 12%. The economy survived. Sort of.
However, we were then in an epic wage-price spiral, no way to break inflation without first breaking the rocketing growth of incomes. S&Ls then were a corner-pocket of the financial system, disconnected from banking and Wall Street. No major financial institution failed ’79-’82, and credit was easily available, just expensive.
Today’s incomes are contracting in real terms, wage growth stagnant. The “wealth effect” is running in reverse, Americans with no resource to tap to offset huge increases in the cost of energy, food, and health care. The big end of today’s financial system is insolvent, broke, liquid but without captial, huge losses still to be recognized; credit shortage spreading to small institutions.
The rock-paper-scissors players in the credit markets have got three things out of whack -- not necessarily wrong, but probabilities misunderstood. The first I just ran through: this is NOT like the last time. This is different.
Second. Inflation risk did reach a new plane with $135 oil, but so did damage to consumers. If you want the Fed to tighten, how deep a recession do you have in mind? You’re not pretending that rate-hike inflation-fighting is cost-free, and the economy has recovered, are you? (Same for the blinkered, one-track “strong-dollar” parade?)
The Fed’s “beige book” says the May economy was “generally weak”; the NFIB small business May survey says “recession” (it has never had a false reading), surveyed earnings in a 1980 pit. May Foreclosures are up 45% from last year (just getting started), and mortgage rates have jumped to the high since 2000, Jumbos at 8% a point higher than that, underwriting standards courtesy of Scrooge & Marley.
I’ve read all the Fed speeches in the last two weeks. The hawkish ones by regional Fed presidents are the worst collection of hack-jobs in my memory (Bullard, Plosser, Fisher...). The ones by Perfesser Bernanke, vice-chair Kohn, NYFed Geithner, the three brilliant managers of the Fed’s finest-hour interventions since January -- these speeches are inspired briefs on inflation measurement and theory, and markets. You must be an inventive reader to find interest-rate policy change in them.
The third thing missed in the credit markets: ’79-’82 conditions are present, but not here. There: China’s retail sales soared 21% last month, inflation 8%. Eurozone wages jumped 3.3% in the first quarter, the Continent drunk on an over-valued euro. Asian central-bank rates are on average 1.7% below inflation, that vastly under-measured because of fuel subsidies. There’s a riot every night somewhere in Asia as those subsidies begin to fail; 30% of Malaysia’s government spending... not for long.
The Fed may have to snug in a dollar sop, and would lean hard into a recovery, but proper policy here is to wait for inevitable slowdown... over there.
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