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Mile High Insights

Fed Governors Give Green Light

01/31/07

The Federal Open Market Committee's (FOMC) decision Wednesday to keep the overnight borrowing rate steady at 5.25% was no surprise. The surprise came earlier in the day, when the government reported 3.5% fourth-quarter GDP growth despite a still-large drag from housing-market weakness. Traders expected the FOMC statement to take a more hawkish tone given the stronger-than-expected growth in the fourth quarter and recent evidence of rising wage pressures. The statement’s wording, however, gave the markets a reason to celebrate. On December 12, 2006 the FOMC had stated: "Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market. Although recent indicators have been mixed, the economy seems likely to expand at a moderate pace on balance over coming quarters.” Yesterday it said: "Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.” In other words, the threat of a recession seems to fade into the distance. This was no surprise to the markets but the fact that the Fed acknowledged that fact and at the same time described the inflation threat as "moderating” after months and months of hawkish commentary was indeed a surprise. Here is what the statement said: "Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.” The FOMC had altered its depiction of the current economy to acknowledge both the strengthening growth that took shape in the fourth quarter of 2006 and lower inflation readings. This was as good of a green light as could be expected and traders took the bone and ran with it. The Dow Jones Industrial rose 98.38 points or 0.78%, the S&P; 500 rose by 0.7%, both just a couple of points shy of a closing high. Joe Brusuelas, chief economist at IDEA Global commented: "This is about as good a disposition as central bankers are constitutionally permitted". Goldilocks is alive and well!


The left chart shows real (inflation adjusted) Gross Domestic Product. The number is released quarterly (adjusted twice thereafter) and shows in its first estimate that the economy grew at 3.5% annualized, which was 0.5% greater than the consensus estimate. The right chart shows the Federal Reserve’s preferred inflation measure, the Implicit Price Deflator. The so called GDP Deflator is one measure of inflation that can not be "manipulated” as some conspiracy theorists would have it. The GDP deflator is not based on a fixed basket of goods (like the CPI) and does not contain the so called owner’s equivalent rent. Therefore, the GDP deflator has an advantage, because it automatically captures changes in consumption patterns and the introduction of new goods or services. It is based on actual purchases and consumption preferences and not on theoretical constructs of indexation. This inflation measure declined markedly during the last 3 months of 2006 (as we had predicted all throughout last year) and probably prompted the Fed to say that "Readings on inflation have improved modestly.” Nevertheless, the Fed statement may have been a bit more hawkish than some expected, chiefly because the Fed upgraded its assessment of both the overall economy as well as the housing sector. "Recent indicators have suggested somewhat firmer economic growth and some tentative signs of stabilization have appeared in the housing market." In addition, the Fed's characterization of inflation was not as upbeat as some would have expected, since they qualified that "... readings on core inflation improved modestly.” That sure does not sound like an interest cut is imminent. If anything, the Fed is still officially biased toward the possibility of future interest rate hikes. The Fed upgraded growth prospects of the economy which even increases the chance of a rate hike rather than a reduction in rates. The truth of it all is that the Fed expects moderate growth and unless growth dramatically accelerates or drops off significantly, we have no reason to expect any moves up or down in the next 6 months. Let's look at two more charts.




The core Personal Consumption Expenditures Index (left chart) has also come down noticeably. Tony Crescenzi said that the overall Personal Consumption Deflator fell for the first time since 1961 and by the most since 1954. This also points towards moderating inflation and should in theory be bullish for bonds, causing interest rates to fall. In addition to the price of money as expressed by interest rates, the quantity of money is an issue which also bears watching. After all, Milton Friedman had said that inflation is always and everywhere a monetary phenomenon. In order to gage the danger of future inflation, we also have to assess the amount of money, which is called liquidity these days. Global liquidity, measured by money supply, is ample. U.S. money supply as measured by M2 (right chart) is growing at a robust pace. Consider that when the Fed began raising interest rates in this cycle back in mid-2004, M2 was growing at an annualized rate of 4.6%. As of the end of December 2006, M2 was growing at a 5.3% clip. The growth rate accelerated in the fourth quarter of 2006, and the December reading was the highest since February 2005. Liquidity increased despite an increasing price of money. In Europe, one year after the European Central Bank began raising interest rates, money supply is expanding at its fastest rate in nearly two decades. The ECB reported Friday that December 2006 money supply rose 9.7% above year-earlier levels. This is more than twice the 4.5% reference rate. In November 2005, the month before the ECB entered its tightening cycle, M3 was growing at a 7.5% pace. In the U.K., M4 grew at a 12.5% year-over-year pace in December. Despite the rate hikes, money-supply growth has accelerated, leaving the world flush with liquidity. This does not necessarily mean that the Federal Reserve has it wrong. Increased economic activity after all requires increased monetary resources. However, the Fed will be carefully watching and I do not foresee an easing under the current circumstances. A rate hike seems more appropriate at the moment. The stock market seams to take rising interest rates in stride. Let’s be mindful, however, that rising interest rates can become destructive to stock valuations. 4.84% seems to be the magic number for 10 year yields to watch. Yields above that level shook up the stock market in the past and might become dangerous to your financial health again.

Hermann Vohs

Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.