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Just how nervous are Alan Greenspan & Co.?
Well find out as the FOMC meets today and tomorrow. I expect a mild increase in interest rates -- and new evidence the Fed is increasingly worried about deficits, the economy and inflation.
By Jim Jubak
This week we should learn if the Federal Reserve's nervous economic tic has turned into a full-blown, inflation-fueled panic attack.
The first signs of anxiety surfaced in the minutes from the Fed's December meeting, where it boosted short-term interest rates to 2.25%. On Feb. 2, the Fed's Open Market Committee will release another statement after its two-day meeting in Washington, D.C. That statement, and the subsequent, more-detailed minutes, will tell me more about the Fed's state of mind than any incremental interest-rate change.
That's because the current extremely low yields on 10-year Treasury notes (just 4.21% as of Jan. 28, despite increases that have taken short-term rates to 2.25% from 1% in less than a year) depend on the bond market's faith that the Fed has inflation under control. And it's that low, long-term bond yield that supports stocks at their current prices. A hint that the economy and inflation might, just might, be getting away from the Fed would raise the odds that the bond market might begin to sell off. The resulting increase in long-term yields could then send stock prices down, as well.
Fed dissenters' 3 worry points
By and large, the minutes from the Dec. 14 meeting of the Federal Reserve's Open Market Committee are full of reassuring self-congratulations. Activity in the housing market remains strong -- and the increase in housing prices has made consumers confident enough to keep spending. Orders and shipments of capital goods are on the increase, showing that the corporate sector continues to invest. The economy is growing at a moderate pace and consumer-price inflation, which ticked up thanks to higher energy prices, will decline in 2005 as energy prices drop back.
But if that was the majority view -- and the view of the committee's staff -- some members felt moved to dissent. It's impossible from these minutes to know how many or who voiced concerns, because the public minutes only say "some" or "a number." But the dissenters flagged three areas of concern:- According to "a number of participants," although inflation was currently subdued, high energy prices and the decline in the U.S. dollar "were still a potential source of upward pressure on prices that could get embedded in higher inflation." That word "embedded" is an especially loaded term for the Fed. The goal of current inflation-fighting theory is to prevent expectations of future price increases from getting embedded in the minds of consumers and corporations. Once people expect future inflation, they behave in ways that almost guarantee future inflation. For example, businesses build up inventories of parts and raw materials in the expectation that they'll cost more in the future. That bulge in orders caused by inventory building leads to inefficiencies in the supply chain. Factories can't meet orders at normal production rates and have to pay overtime, for instance. Those inefficiencies then lead to rising production costs, which produce exactly the kind of price increases that the companies building extra inventory feared. If higher energy prices and a decline in the value of the dollar that made imports more expensive led to this kind of inflationary expectation, then the Fed would have lost an important battle in the war to keep inflation under control.
- According to "a few participants," it isn't quite clear where the current economy is in the business cycle. That could present a big problem to the Fed. If you don't know how close the economy is to the top, for example, you could add too much economic stimulus and trigger inflation; if you don't know how close the bottom is, you risk adding too little stimulus, which could lead to a recession. These dissenters "noted that the uncertainty about the resource slack in the economy was considerable and that it was quite possible that the economy could soon be operating close to potential." The majority view, on the other hand, has been that there's plenty of extra industrial capacity and plenty of extra workers so that keeping interest rates low and only gradually raising them wouldn't lead to inflation. If, however, the economy is close to full capacity, the Fed might wake up one day to find that the recent slow increase in rates has let too much stimulus go on for too long and has tipped the economy into inflation. Then the Fed would have to suddenly abandon its slow step-by-step interest-rate increases and really step on the brakes. That would send the bond market tumbling.
- "A number of participants voiced concerns about domestic and global financial imbalances." In other words, these dissenters are worried about "the magnitude of current and projected fiscal deficits." Yes, the federal government seems committed to bleeding red ink year in and year out as far as the eye can see. "Some participants believed that the odds of significant deficit reduction over the next few years were remote." That would leave the Fed as the only combatant in the fight to contain inflation. But that's not the only imbalance that makes these folks nervous. There's also the U.S. trade deficit, now running at record levels. "Regarding global imbalances and the current account deficit in the United States, a number of participants expressed doubts that such imbalances would be reduced in the near-term." The only way to reduce this deficit is for 1) U.S. consumers to buy less or 2) for foreign economies to grow faster so overseas consumers will buy more. The dissenters call either result unlikely.
So many problems, so few solutions
I don't know whos right, the worrywarts or the Pollyannas. (You can read the minutes for yourself here.) But the disagreement is based on something beyond the usual dismal record of the dismal science in projecting the future. The dissenters are anxious because they know that the number and magnitude of the problems the Fed faces keep growing, while solutions are limited.
At the end of the Clinton administration and the beginning of the Bush administration, the U.S. central bank kept a recession mild and prevented the economy from sliding into a painful downturn. The Fed solved its problems by trimming interest rates and increasing the money supply, which pumped up the housing market and provided a wealth effect that made consumers forget about the money they lost in the stock market. Then there were tax cuts from the Bush administration and Congress, which boosted the economy.
Contrast then to now. The economy is chugging along at a decent 3% growth rate that appears self-sustaining. That's a good thing, since the Fed nearly exhausted its interest-rate flexibility fixing the last downturn when it took short-term rates down to 1%.
Now the challenge is keeping growth chugging along while preventing any resurgence of inflation. To fight inflation, the Fed can increase interest rates -- but not too fast, please, or the economy might slow. In its inflation battle, it can't count on help from the federal government, which is busy piling deficit on top of deficit. The declining U.S. dollar is no inflation fighter, either: It makes imports more expensive and gives U.S. producers the power to raise prices, which all adds to domestic inflation. The Fed can, of course, support the dollar by raising U.S. interest rates, but again, too big a rate hike and the economy could slow.
The inflationary impact of higher energy costs is even more of a problem for the Federal Reserve because the bankers have no way to force down the price of oil. They know the only way to reduce demand is to slow the U.S. economy. That's not a particularly attractive alternative.
And lastly, the huge U.S. trade deficit puts upward pressure on U.S. interest rates as foreign investors need to be "convinced" to hold ever larger numbers of dollars by the argument of higher returns. There's little the Fed can do to reduce the deficit, either. The choices are to slow the U.S. economy -- bad -- or to get foreign governments to increase the growth rates of their own economies -- tough.
A-OK unless Fed's worries show
I guess you can see why the Fed dissenters might be getting a bit anxious. They know the financial markets -- here and around the world -- are counting on them. They know that the job is getting tougher by the month. And they know that no one in Washington, Beijing, Tokyo, London or Frankfurt is lifting a finger to help.
On Feb. 2, I expect the Federal Reserve's Open Market Committee to follow through on its recent policy. Interest rates are likely to go up another 25 basis points. The committee is likely to issue a statement saying the risks of inflation and slower growth are balanced. Future rate increases will be measured.
The financial markets won't be surprised by this, and the reaction is likely to be muted. Markets don't go up or down much when investors' expectations are met.
But watch out if the Fed lets its anxiety show -- by not raising rates, by changing the formula in its statement or, more likely, by continuing to signal dissent when its minutes are released.
In the back of their minds, the financial markets already have a nagging worry about the Fed. Alan Greenspan's 14-year term on the Board of Governors ends in January 2006. Greenspan will be 79 this March. The Fed without Greenspan? That alone is enough to make the markets jittery.
Investors don't want to be reminded that even the powers of Greenspan's Fed might not be enough to meet all the current challenges.
New developments on past columns
5 stocks for the coming technology rally
Another solid if not great quarter for Texas Instruments (TXN, news, msgs). Another disappointing announcement on the next quarter. In its Jan. 25 earnings report, the company continued the pattern that kept the stock stuck in the doldrums for much of 2004. Revenue of $3.15 billion for the fourth quarter fell by 3% from the third quarter of 2003. That was still better than Wall Street expected and up 28% from the fourth quarter of 2003. Earnings of 28 cents a share came in two cents a share above the Wall Street consensus (mostly on a lower tax rate) but gross margins fell as the company worked to reduce inventory. For the first quarter, Texas Instruments guided to revenues of $2.9 billion to $3.14 billion: The midpoint of that range represents a 4% drop from the fourth quarter of 2004. At 24 cents a share, earnings for the first quarter will be down from the first quarter but up 13% from the first quarter of 2004. Margins are likely to improve in the second half of the year as the company works off its inventory problems but 2005 looks likely to be a year of slow growth for Texas Instruments. I think the stock is worth holding for a February bounce after the January correction, but I'll be looking for an exit point if the stock climbs near the top of its price channel around $26. As of Feb. 1, I'm setting my target price at $25.50 for March 2005.
Transport winners will keep on trucking
Now that was a good quarter. Revenue at Burlington Northern Santa Fe (BNI, news, msgs) climbed 20% to $2.98 billion in the fourth quarter, the company announced on Jan. 25. That was well above the $2.86 billion projected by Wall Street analysts. And, as I wrote in my Jan. 11 column, at high-fixed cost businesses like railroads you can expect an increase in revenue to send earnings soaring. Net income rose to $347 million, or 91 cents per share, for the fourth quarter from $226 million, or 61 cents per share, in the fourth quarter of 2003. That was 17% above the 78 cents a share Wall Street had expected. I think investors can count on this leverage to keep working its magic for the rest of 2005 at least. Wall Street analysts have upped their earnings estimates for the first quarter of 2005 to 69 cents a share from the 62 cents a share projected 90 days ago, and for all of 2005 to $3.37 from $3.12 a year earlier. As of Feb. 1, I'm raising my target price to $55 a share by December 2005 from my earlier target of $53.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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