Navarro's Big Economic Picture

So far in 2006, everything looks, tastes, and feels like a bull market.  Good price and volume action.  Rallies after pullbacks.  Light volume on flat days.

Iâ�,��"�d recommend reading Michael Santoliâ�,��"�s Market Watch column this week in Barronâ�,��"�s as he astutely distinguishes between the bullish investor sentiment noted last week by Matt Davio as a contrarian indicator and the bearish sentiment of the retail investor â�,�“ with the two big groups fighting it out in contrarian fashion for the hearts and minds of this market (and me). 

In the meantime, Iâ�,��"�m going to deal with a longer run theme for 2006 that speaks to the issue of whether the Fed is going to stop raising interest rates any time soon.  This analysis was published as an oped in this weekâ�,��"�s weekend edition of Investorâ�,��"�s Business Daily (with IBDâ�,��"�s Big Picture column one of my daily staples.)  So here it goes â�,�“ and itâ�,��"�s well worth your time to slog through what is a complex but important argument.

The Real Federal Reserve Conundrum
Is the Federal Reserve done raising short term interest rates?  That question is of great interest to everyone from business executives and investors, and the answer hinges on a concept as simple to define as it is difficult to determine â�,�“ market neutrality. 

The Fed Funds rate is said to be market neutral when nominal short run interest rates are equal to the rate of inflation plus an appropriate real rate of return that reflects the risk of holding short term government paper.   The Fed seeks market neutrality because it is presumably at this point that monetary policy is neither too tight nor, as it likely has been in much of the period since 9/11, too accommodative.  At this point, the Fed will be in the best strategic position to engage in discretionary interest rate hikes or cuts should the economy overheat or falter.

It follows, then, that the question of whether the Fed should be done after 13 rate hikes boils down to the question of whether a Fed funds rate of 4.25% constitutes market neutrality.  At least using the traditional formula of the last three decades, the answer is clearly yes. 

The traditional formula uses the â�,��"core rate of inflation,â�,� as measured by the Consumer Price Index minus the effects of food and energy prices, as its proxy for inflation in the market neutrality equation.   Given that the current CPI core rate is 2.1%, this implies a real rate of return to investors on short term government paper of more than 200 basis points.  This is a return that, at least by historical standards, is clearly robust â�,�“ and may arguably even signal, as the recently inverted yield curve suggests, that monetary policy has become too tight.

So why is does the Fed remain uneasy about inflation?  The answer to this next question may be found in the logic â�,�“ or perhaps lack thereof â�,�“ of leaving food prices, and particularly energy prices, out of the core rate of inflation.

The traditional logic of calculating the core rate â�,��"ex food and energyâ�,� is that both are characterized by volatility rather than persistence.  That is, over any given economic cycle, food and energy prices are just as likely to go down as up â�,�“ depending on whatever random shocks may be occurring at the time.

For example, with food prices, it may be a drought or a flood or a freeze that causes wheat or corn or orange juice prices to spike in one year while in another year, a good crop may send prices plummeting.   Similarly, oil prices may spike on geopolitical events as they did during the Arab oil embargo of 1973-74, the Iranian Revolution in 1978, and the two Gulf wars.  However, over time, oil prices always fall back down, e.g., by the mid-1980s, real oil prices were below pre-embargo levels â�,�“ or so the volatility argument goes.  Of course, based on the observance of this historical volatility rather than persistence, it has always seemed prudent to calculate the core inflation rate â�,��"ex energy and food.â�,�

The important question the Fed is now confronting is whether future oil prices will be characterized not by volatility but rather by persistence.   The argument for what is essentially a stunning â�,��"regime changeâ�,� in the calculation of the core rate is one based on a threshold demand effect driven in large part by the emergence of both China and, to a lesser extent, India as large and growing consumers of energy.

In this â�,��"persistence scenario,â�,� oil prices do not float back down to $20 or $30 dollars.  Rather, they have already begun what is likely to be a decades-long trend up towards a $100 a barrel and perhaps well beyond.   In this scenario, energy inflation clearly must be considered as part of the core rate because of its persistent effects on production costs and the supply side of the global economy.

This is the true Fed conundrum â�,�“ whether we are now in a world of persistent rather than volatile energy and commodity prices.  If we are in a world of persistence, suddenly a Fed Funds rate of 4.25% may not look like market neutrality at all. 

Consider that when energy price inflation is inserted back into the core rate, the adjusted core approaches 3.5%.  This implies a real return for short term investors less than 100 basis points.  At least from the perspective of inflation hawks within the Fed, this may imply a continued slog up the short end of the yield curve, perhaps right through the end of the year. 

If the Fed does indeed insist on such a long, slow slog, it would effectively cool down the entire global economy and certainly tamp down energy prices and inflationary pressures.  If, however, it turns out that the Fed is fundamentally wrong in its implied beliefs about the new persistence of energy price shocks, the costs to the global economy and financial market investors of this long and inevitably recessionary march will be both steep and unnecessary.

Hedging Your Bets With Matt Davio: Moving, Moving, Moving

It seems that Ben "Helicopter Drop" Bernanke is getting a jump-start on expectations that he will be an 'easy money' Federal Reserve Chairman.  The Fed undertook the largest one day open market operations since the week of September 11th, 2001 during this past Wednesday.  This massive stimulus followed a heavy week of liquidity injections during the final week of 2005. 

This massive liquidity injection partially explains the run-away stock and gold markets of the first two weeks of 2006.  And it also explains the rapidly weakening dollar...

But while the liquidity injections in September 2001 made sense, the only 'crisis' that I can see occurring right now is the retirement of Chairman Greenspan.  Could the Federal Reserve be so insecure about incoming Chairman Bernake that they risk destabilizing the financial markets with huge and unnecessary liquidity injections?  Does outgoing Chairman Greenspan think so highly of himself that he believes no one else is up to the job of without an added boost of adrenaline?  Or is the economy not growing fast enough for the embattled Republican administration that they feel an extra boost is need for their popularity polls? 

Whatever the reason, it's a highly disturbing event because it implies a much more aggressive management of the financial markets by the Central Bank.  And that's a dangerous precedent because in the near term the additional liquidity is highly stimulative.  But the effects are similar to the experiences of a habitual drug user.  The Fed will have to inject more and more liquidity to stimulate the markets which will eventually lead to complete collapse.   

Now, letâ�,��"�s shift gears at bit and look at a couple of really interesting chartsâ�,�  The first chart just gives you an overview of the great bubbles of the last 50 years â�,�“ from gold and the Nikkei to the Nasdaq and maybe, just maybe, the housing market.