Note: Professor Fleckenstein provides his commentary every Wednesday evening for educational purposes - his insights are not intended as investment advice. You can find his daily comments at www.fleckensteincapital.com.
Serpent of Inflation Penetrates Fed's Garden of Eden
Overnight markets were a nonevent, as were our equity futures. The market opened slightly to the plus side, then worked its way higher, such that approximately an hour into the day, the Nasdaq was up about 0.75%, and the Dow/S&P about half that. Everything was slightly green, with tech being the "greenest." I saw nothing remarkable worth commenting on.
Bull & Bear Go Long D-U-L-L
After the early-morning effort higher, the tape backed off until about midday, and then we had another attempt at the upside. With about 30 minutes to go, which is when I snuck out a little early, the Nasdaq was up almost 1%, and the S&P and Dow were up fractions of that. The day continued as it began, modestly green, with no particular theme that I could discern.
My guess is that folks are idling until Friday's employment report, at which time they can decide whether they want a strong number, and its implications, or a weak number, and its implications. There's some chance that tomorrow will be rather dull, like today was, but then again, you never know.
Away from stocks, the dollar was weak against the yen and the euro. The Canadian and Australian dollars were mixed. Precious metals were quite a bit higher overnight, with gold up almost 1% and silver up a couple percent, but they gave up part of their gains during New York trading, to close 0.5% and 1% higher, respectively. Fixed income was still heavy, with long-bond futures down roughly one-quarter point.
Fa-la-la-la-la, Fed Fallacy
Now I'll discuss a story I've wanted to cover for a few days from last Friday's Wall Street Journal, titled "Fed May Have Acted on a False Alarm." This very important piece basically shows that the Fed (in an attempt to justify its spewing out of liquidity) has argued logically from a false premise to arrive at the false conclusion that inflation is completely under control.
Writer Greg Ip began: "The Fed may have been responding to a false alarm last year when it cut interest rates to four-decade lows and held them there over fears of deflation, a Federal Reserve Bank of Atlanta study suggests. The study concludes that much of the drop in inflation between 2001 and 2003 was due to unusual behavior of residential rents and used-car prices indirectly caused by low interest rates. 'These results suggest that the concern and discussion regarding overall price deflation were perhaps overstated,' the Atlanta Fed economists conclude."
Ip's follow-up comment: "If the study is correct, underlying inflation may not be as low as it appears. Further, it suggests that once the Fed begins to raise rates, the unusual behavior of used-car prices and rents may stabilize or reverse, pushing up measured inflation rates. . . . "
Rotten to-the-Core CPI Math
He went on to note that from November 2001 to December 2003, the supposed CPI "core rate," ex food and energy, dropped from 2.8 to 1.2, which is of course what got the Fed heads all lathered up about deflation (or gave them the smokescreen they desired -- whichever it was). Specifically, Ip pointed out: "The study finds that two-thirds of that decline in the core inflation rate reflected slowing increases in rents and rapid declines in used-car prices."
Continuing on, he talked about how once the Fed began to drive rates to absurdly low levels (which now have the funds rate at about one-third to one-quarter of the underlying inflation rate), its actions chased a lot of people from apartments into houses. Of course, that helped take down the aforementioned rental rates, which helped hold down the CPI's housing component, since the latter is composed of rental equivalents. To quote the Journal story: "Rising apartment vacancy rates restrained rent increases. That also indirectly held down the measured cost of owner-occupied housing, which is based on rents for similar housing units rather than house prices."
Al's Hot Pursuit of an Apparition
We then get to the punch line, by Atlanta Fed members Andrew Bauer and Nicholas Haltom, who stated that those developments "reflect not a fundamental weakening in housing and vehicle demand, but, instead, the dynamic effects of interest rates on consumer demand for substitutes." Basically, the Fed was chasing the tail of something that didn't exist. It lowered rates, which due to how the CPI is calculated, helped force the housing-cost component down, when the very actions taken by the Fed were forcing up the price of houses. But of course, this was not captured by the statistic.
The article noted that this thought process does not represent mainstream thinking within the Fed. I am not the slightest bit surprised about that, because we know what the mainstream thinking is at the Fed: Keep the pedal to the metal, no matter what. Obviously, the Fed does not even believe the economic data it so busily cheers continually, as it refuses to raise rates to anything representing a reasonable number.
Basically, the Fed made up an excuse for printing money so it wouldn't have to address the real problem, which was the prior stock mania. The Fed succeeded in creating the housing mania. And now, as I said at the end of my column yesterday, it is trapped in a position where it can't raise rates to head off the inflation problem that it has now created.
Easy Begets Sleazy
Meanwhile, it has precipitated an enormous credit bubble in housing. Every day, I must get a handful of solicitations like the one I received last night: "If you are paying more than 3.6% on your mortgage, we can slash your payments!" The pitch continued: "We have the guaranteed lowest rates on the planet and approval regardless of credit history."
These come-ons have been occurring everywhere. They have helped exacerbate the reckless speculation that we see in housing today, which was wonderfully described in a story titled "As Household Debt Rises, New Risks in Higher Rates," in yesterday's New York Times. After chronicling the action of some folks willing to bet it all that housing prices will keep going up, and rising interest rates won't hurt them, the article cited all the speculators seeking lower-rate ARMs to be able to shoehorn their way into houses. The percentage of adjustable-rate vs. fixed-rate applicants has recently jumped to 32%, from about 13% a year ago, indicating that about one-third of home speculators are taking Easy Al's advice to go with floaters.
I thought the best quote was the last one, from a real-live mortgage banker: "It used to be that everyone wanted a fixed rate, and now there I am, getting calls for all these ARMs with interest-only payment options. Actually, I am getting ready to settle on a beach property for myself, and this will probably be an interest-only loan." Here's a fellow in the mortgage business (who should know better) clamoring for an ARM, alongside all those folks at home, while in the meantime, 1% rates have really nowhere to go from there -- and the Fed is indicating it's finally going to take them higher.
A Not-Pretty End to a Party
The amount of damage that is going to be done when this housing bubble unwinds will make the damage done from the bursting of the stock bubble look like a picnic. Of course, when the housing bubble unwinds, the economy is going to go with it, because as I have stated, folks have been using their houses like ATMs.
The Fed has engineered us into a spot where the consumer has no more cookie jars to tap and has now boosted his debt to record levels. The Fed has to raise rates, but can't possibly do so at a pace fast enough to change anyone's inflation expectations. We are on the path toward a train wreck. When that occurs, and exactly how it occurs, is yet to be determined. After it occurs, we will perhaps have to think about deflation. But in the interim, it would appear that the Fed has finally created a set of problems for itself, from which there is no escape.
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