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The Monetary Car Looking in the Rear-View Mirror


The Fed continued to raise short-term interest rates, but on this 17th consecutive hike to 5.75%, the language was subtly different.

Note from Professor Vitaliy: The writer of this piece, Michael Conn, is a president and founder of Investment Management Associates, Inc. He is a Chartered Financial Analyst and has been in the investment industry since 1968. Michael and I work side by side and look at the world in a similar way, the only difference is he's been doing this a bit longer (OK, he has ties older than me).

The Fed continued to raise short-term interest rates, but on this 17th consecutive hike to 5.75%, the language was subtly different. The previous increases were accompanied by statements that could only be interpreted as "hawkish" on inflation, setting the stage for further increases. This time reference was made to moderating economic growth, hinting that rate increases may be at or near an end.

Inflation numbers have increased in the last three months at a rate over 3%, this, in concert with high oil prices, a housing bubble which is only just beginning to deflate and an economy that grew at a surprising 5.6% annual rate in the first quarter. To some extent the Fed drives the monetary car looking in the rear-view mirror. For example, the fastest-rising element of CPI in recent months has been "imputed rent" which attempts to adjust the cost of housing monthly. This element accounts for about 30% of the CPI and is at a high just as housing prices have begun to soften. Of necessity, the Fed extrapolates trends, but this is often not very good at identifying inflection points. Without a doubt, there is a lag in the effect of their actions. Commodity prices have likewise begun to show weakness, and while the new Fed chairman will have to reinforce his credibility as an inflation fighter, the recent hike in rates or one more in August may mark the end of the increases. The Fed statement was that they will be "data dependent" going forward. The latest figures on manufacturing and construction indicate slowing but employment reports are likely to have the biggest impact.

The important question is whether 5.75% or 6% will have enough of an impact on the economy to produce a recession, or allow a "soft landing" with continued, if moderating growth. The economy likely slowed in the second quarter, and while corporate profits are not advancing at the 20% rate seen last year, they are still likely to grow in double figures this year. Wariness over consumer spending is certainly justified, as household debt is at record levels. However, household net worth is also at record highs. This is not all due to real estate values, as over the last year the value of household financial assets is up $3.2 trillion while home equity is up $1.5 trillion. A deflation of regional real-estate bubbles does not necessarily portend serious damage to consumer spending. Corporate balance sheets are also in good shape, with net worth up, debt-to-equity down, and cash flow outpacing capital spending.

Some point out the age of this recovery as a sign that a recession is on the horizon, but age is less of a determinant than the pressures caused by overly optimistic hiring, capacity expansion, and inventory build-up, none of which seem to be occurring. The seventeen hikes in interest rates have come from the extremely accommodative low rates helping the recovery from the last recession. The current rates are neither accommodative nor restrictive, but neutral in the face of a natural slowing of growth to a hopefully sustainable rate. Hurricanes or other exogenous events can alter this scenario, but at this time we do not see a high risk of a decline in the economy.

The stock market reacted positively to the Fed's comments, and like the economy, looks to us to be pointing to positive, if modest gains, in a framework of volatility with each new set of data.
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