| ECRI leading indicators have imprved, $ supply still growing |
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Jon
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Joined: 13 Apr 2005
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| ECRI leading indicators have imprved, $ supply still growing |
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One big worry earlier in the year was ECRI�s weekly leading indicator index. That index was falling, not indicating recession, but falling. If it continued to do so it would start forecasting a recession ahead. Over the past few weeks, however, it has stabilized and is trying to turn back up. Thus there was no confirmation of the weakness and for now that suggests continued expansion. This is a solid indicator, so when it speaks you have to listen.
How long can it hold the line? Gasoline prices will play their role and of course so will the Fed. We heard Kohn Thursday and his Phillips Curve/demand driven dogma that is on par with the alchemist�s attempts to turn lead into gold. In short the idea is if we get too prosperous with people working and factories humming, inflation automatically arises. Hmmm. Tell that to the economy from the early 1980s into 2000. No inflation then even with surging employment and lots of capacity usage.
One thing the Fed is not doing that it did in 2000 is drying up the money supply. Money continues to grow impressively, with M2 rising $23.1B to $6.978T in the first week of April. M1 jumped $34.8B to $1.4T. This continues a steady, 2-year expansion in M2. The Fed may be raising rates, but there is a lot of money still out there if you are willing to pay a higher price for it. Rates alone are not high enough to cause the slowdown yet; if gas prices get high enough they will have a much more profound impact in a much shorter time. Thus the Fed is keeping money supply pretty high so things don�t seize up as they did in 2000. It is a tough spot for the Fed as it wants to avoid the 2000 bungle yet keep growth with inflation at bay. All of that money makes the task hard; as noted last week, Steve Forbes says there is too much sloshing around, threatening more inflation. With gold running away it is easier to draw that conclusion as well.
Fed trying to avoid the 1970�s all over again.
As we wrote about in 2004 and early 2005, this inflation pressure has its roots in how the economy recovered from this recession. Demand never really substantially slackened during the recession due to the unique events including 9-11. People poured money into their homes with remodeling, etc., and that kept the demand side of the equation moving forward. Supply (business) investment, however, died for three years. No new investment, no new technological innovation; just stagnation. Then the first incentives were demand driven (remember the rebates?). It was not until the tax cuts and investment incentives passed that there was renewed investment in the supply side. By then, however, the seeds of inflation were sewn because supply had been playing catch-up to demand ever since. Inflation occurs when there is excess liquidity coupled with demand exceeding supply. Supply has lagged all along because of increased demand incentives as the first fiscal incentives and business� reluctance to invest after getting burned so bad in the 2000 meltdown. Business was very distrustful of governmental action at that time; it was the Fed and excess tax collections that led to the cataclysmic meltdown. Thus, they were even more hesitant than usual to get back into the game.
Thus we are in a period threatened with inflation on one hand and the destructive force of high energy prices on the other. Energy prices are not inflationary; they destroy more demand than an inflation pressures they produce. The Fed is raising rates on the one hand but keeping money supply strong on the other, trying to walk a tightrope. It is a very treacherous path and some like to compare it to the 1970�s. At that time, however, the US economy was burdened with incredible governmental obstructions and was already in a malaise before the energy crisis hit. Fed governors who were on the FOMC at that time warn about �monetizing� the higher energy prices as they did in the 70�s and thus triggering nasty inflation. We have a strong economy this time and the Fed needs to recognize the difference.
In the 1970�s there was no business investment, and the massive liquidity when straight into consumer demand. Inflation shot out of control. This time we have business investing (finally) and we don�t want to choke that off with rates that are too high and then end up where we were in the 1970�s with demand forcing up inflation. That is why the Fed is keeping money supply rising as it raises interest rates. It is trying to strike a balance where money costs more so there is not too much easy money, yet money is available for businesses to expand supply. The balancing act really gets critical if energy does spike. If the Fed has raised rates too much the demand destruction will outstrip any so-called �neutral� monetary policy stance.
Of course this all assumes the Fed is looking ahead. Its rhetoric is rearview mirror as we heard Thursday from Kohn. You would like to think the Fed is applying the type of analysis we just walked through, and you would think so given the massive amount of collective brainpower on the FOMC. As we have said before, however, all of the firepower is no good if emotion takes over and starts calling the shots. Unfortunately for us, the Fed�s history time and again is one where emotion apparently overcomes reason because time and again the Fed cites lagging indicators as reasons for hiking rates to the point where the economy gags.
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Tue Apr 18, 2006 12:26 pm |
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