Caution!

The following rumor about the next change in interest rates has no basis in fact, but is only the result of the Optimist’s imagination.  Please do not make any trading decisions based on this questionable rumor!  OK.  Now that I’ve dutifully warned all to ignore everything I am going to say in this commentary, I can feel free to start a rumor about the next change in interest rates.  My total lack of any factual basis for this rumor is only a minor distraction to keep in mind as I tell you what could happen to interest rates and related markets after the Fed meets next week.

And you thought you have problems . . .

Incoming Fed chairman Bernanke has three immediate problems.  First, all the usual suspects (energy, precious metals, base metals, housing bubbles, etc.) have advanced to multi decade highs in clear evidence of escalating U.S. and worldwide inflation.  Second, a new Fed Chairman who may be best known for his exploits as a helicopter pilot and his skills at greasing the wheels of the electronic equivalent of a printing press will not get much respect from the markets.  He will need to show action before he can simply talk the markets into following his direction.  Third, the mid term Congressional elections are less than 11 months away.  One could expect the Administration to pull out all the stops for their favored candidates, and an obviously deepening recession in the fall would not be politically correct timing.

The old song and dance is boring

So, what could our new Fed Chairman  do to quickly step past those problems?  Either cutting interest rates, or holding them steady now, would only make all three problems worse.  They would add fuel to the fire which is already causing inflation sensitive investments to boil over.  That action would be seen as solid evidence that the Fed is not concerned about the evidence of increasing inflation, and would embolden the bulls to push the market prices every higher.  If Paul Volcker was a hawk on inflation, and Alan Greenspan waffled around near the dove end of the spectrum, then the first impression of a Fed chairman who dropped interest rates or held them steady now would be somewhere between a dove and beyond that toward wimp.  Some people like to start at the bottom so they will have abundant room to move up, but I don’t think our new Fed Chairman is a member of that low expectations club.  Finally, passively accepting increasing evidence of higher inflation now could cause a serious timing problem later if the Fed becomes forced to drive up interest rates in the months before the Congressional elections.  Simply notching rates up another boring quarter of a point would do little to improve any of the negatives listed above, and would give the impression that Bernanke is almost invisible under Greenspan’s shadow.

A bold solution

The rumor that I am now starting is that the new Fed Chairman may choose the bold action of increasing rates by a half point, or even three quarters of a point next week, accompanied by clear and forceful language that the Fed will be ever vigilant against rising inflation in the future!  No doubt, everyone who reads this will consider that possibility, and the Optimist, to be somewhere between far fetched and certifiably deranged, but consider how such an unexpected action would impact on Bernanke’s problems.  The shock of the news would immediately translate into sharp sell offs in stocks, energy, precious and base metals, etc.  The all important housing bubble would not be seriously disturbed because mortgage interest rates would drop due to the rise in long term bonds, in the same way they have defied economic gravity through the last dozen rate increases.  Debt stressed consumers would show their pain through plummeting consumer confidence and reduced purchasing which the news media would focus on as foreshadowing a depression.  That should effectively put inflation back into an out of sight and out of mind box, in which it can continue to grow by monetary expansion without all the negative publicity generated by high prices in energy and metals.

The new Fed Chairman would be immediately perceived as a strong leader who takes his responsibilities against inflation seriously, and who is willing to prescribe potent medicine to cure the ills of the economy.  The press will immediately forget the name of Greenwho? and begin to headline the amazing similarities between Bernanke and Volcker.  Within only a few days, the new Fed Chairman will become a legend in our own minds.

Good timing

Popping rates higher by a half percent or more now will also solve the timing problems related to the next Congressional election.  An immediate sharp drop in consumer confidence, matched by similar drops in stocks, energy, and metals, will quickly have the news media talking only about the coming recession or worse.  By the next Fed meeting, they will be able to announce that the risks are evenly balanced by inflation and deflation, so they can hold rates steady.  As an exercise for the students, compare and contrast the results from raising a boring quarter point now and another quarter point at the next meeting, versus a bold half point increase now and no increase at the next meeting.  The following Fed meetings will show the timing value of a sharp increase in rates now.  By then,  the media will talk about little more than the dreaded deflation toward which our economy is surely falling, and the Fed will be able to cut rates by a half point at each of the next few meetings to protect us from the dastardly deflation fate which would otherwise crush our economy (despite the contrary evidence offered by energy and metals prices which will be setting new record highs).  Those sharp rate cuts over the spring and summer, combined with the ever increasing M3 money supply which will no longer be published, will have our economy running at full speed again by late fall, and will push stock prices to record highs.  Coincidentally, that will put voters in a good mood by November.

Deflation?  Not in our lifetime!

Lest any readers become disoriented through the dance that would begin with an unexpected sharp rate increase next week, I’d like to provide a roadmap of what to expect in the following months.  The chart below, courtesy of Robert Sahr, shows prices from 1665 through 2005.  For the 250 years before the Fed was chartered in 1913, prices were not as stable as some might believe.  Even though the U.S. dollar was as good as gold for most of that time, prices were on a roller coaster ride with major price swings of almost plus or minus 50 percent above and below before returning the price level to the mean.  Those were serious episodes of inflation and of deflation, in never ending cycles.  Fortunately Congress had the wisdom to charter the Federal Reserve to smooth out the cycles in the economy.  A quick glance at the results after the Fed took control show the indisputable accomplishments of the Fed.  After 1913, the Fed was able to dramatically reduce the volatility of prices in the economy.  With the sole exception of a small price decrease in the 1930s (when the Fed was constrained by overseas convertibility of the dollar to gold), the Fed masterfully cut the price volatility in half by simply enhancing the inflationary booms which most people thought of as being good, and simultaneously eliminating the deflationary corrections of the previous distortions, which most people thought were economically painful.  Keeping all the advances in a market’s price action, while also preventing all the declines, is a very effective way to reduce volatility!  This chart clearly shows the power of the Fed to push inflation relentlessly higher, and to prevent the bouts of deflation which are needed to return prices to the same level at which they started the cycle.

I will bet with the Fed

The market adage “Don’t fight the Fed.” is always good advice.  The chart shows the consistent direction in which the large foot prints of the Fed marched for more than 90 years.  During that time, the Fed has had well publicized battles against inflation, but all the public relations stories about fighting inflation, and the media hype about the dangers of deflation, have not had substantial impact on the results generated by the Fed.  I anticipate yet another round of scare stories about the risks of deflation in the months ahead, and other investors may choose to hedge against those fears if they like.  Until I see convincing evidence that the Fed wants to move prices in a different direction than in the past, however, I intend to continue deploying my investments in line with the path the Fed has consistently followed.  Cheers!

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