Jubak's Journal Recent articles: • Katrina is no disaster for insurance stocks, 9/21/2005 • 5 baby blue chips you should know, 9/20/2005 • Has Congress sparked a banking crunch?, 9/16/2005 More... | Jubak's Journal How the Fed lost the inflation fight Despite powerful tools, the Fed looks feeble against today's storm of inflationary pressures. Here's why inflation is winning out. By Jim Jubak The Federal Reserve has lost the battle against inflation. Oh, sure the bank will keep raising interest rates -- as it did on Tuesday, when it increased the federal funds rate to 3.75% -- in an effort to fight rising prices. And, sure, measured core inflation -- the rate of increase in prices minus food and energy -- is up at an annual 1% rate in the last five months. But the battle is over, nonetheless, whether the Federal Reserve will admit it or not. (And I'd guess "not," since saying anything else would send the financial markets into a tizzy.) Why? Because actual future inflation is driven by current expectations of inflation. In other words, folks raise prices because they expect inflation in the future. And because the factors setting current expectations of inflation are largely outside the Federal Reserve's control, there's very little Alan Greenspan & Co. can do to stop an inflationary psychology from becoming embedded in the economy. Let me explain why I think the battle is over and inflation has won.
The Federal Reserve has powerful weapons for fighting inflation.
Shutting down an easy trade And these weapons have shown some of their historical ability to move the financial markets. So, for example, the 11 increases in short-term interest rates since the Federal Reserve began raising rates on June 30, 2004, have just about closed out the carry trade that let banks and investment banks, bond traders and hedge funds of all flavors make money by borrowing at low short-term rates and then lending (or buying) at higher long-term rates. The yield spread, though, between a 10-year Treasury note (yielding 4.18% as of Sept. 21) and a two-year Treasury note (yielding 3.94%) has just about vanished. And the spread between the 10-year note and the Fed funds rate after yesterday's rate increase is down to just 0.43 percentage points. That's a huge decline from the gap in June of 2004, of 3.75 percentage points, that enabled bond traders to mint money. Related news and commentary on MSN Money That shrinkage in the spread has, as you'd expect, cut profits throughout the financial sector and looks set to cut profits more. For example, Annaly Mortgage Management But even in the financial markets and on Wall Street, the Fed's moves have had much less effect than they used to. Thanks to the derivatives market -- a largely unregulated market that dwarfs the amount of actual U.S. currency in circulation -- traders, speculators, and even many who would once have been called investors think they can keep the game going in spite of the Fed. (Ill have a column soon on that topic.) The Federal Reserve's power over the financial markets just isn't what it used to be. The supply side of the equation The traditional inflation-fighting weapons aren't very well-suited to damping inflation in the current economy. First, because this is supply-led rather than demand-led inflation, and second, because the prime source of inflationary expectations is our federal government in Washington. Federal Reserve interest-rate increases, slowing money-supply growth and other traditional policy tools are most effective in fighting inflation when potential price increases are demand-driven. In other words, making money more expensive or less available is a pretty good way to fight inflation when companies start to raise prices because of growing demand for more of this and more of that. But current inflationary pressures are, while still linked to demand, more supply-driven. For example, it's because OPEC (the Organization of the Petroleum Exporting Countries) has no surplus supply of oil to put on the market -- at any price -- that oil prices have soared, driving up the cost of everything that runs on or is made from petroleum. This isn't just an OPEC problem: OPEC notes that while, since 2000, it has increased its production of sweet crude, the only kind that many older refineries can turn into gasoline and other petroleum products, global production has actually dropped. The global economy is supply-constrained in industries from mining to lumber to oil refining, largely because companies haven't invested enough in production capacity over the last few decades. There's no puzzle or global plot here, just economics. The profits in many of these industries were so low that nobody invested in new production capacity. The good news is that this cycle will turn, as such cycles do, as current high profits, created by this very lack of supply, are invested in new capacity. Eventually supply will catch up -- as long as the profits are there, it always does. (Unless the world is indeed facing a growing shortage of discoverable and recoverable oil, and the jury is still out on that one.) And if this cycle is like most, companies will overinvest, lured by current and temporary high profit margins, setting the stage for a period in many of these industries when supply again exceeds demand. The bad news, however, is that building new capacity to produce the basic materials in such short supply can't be done overnight. We're talking about developing iron and copper mines (after exploration companies have discovered the new deposits). About drilling for oil in deeper and deeper water -- or in politically more and more unstable countries. About building new refineries and smelters to turn raw materials into consumable goods. And about constructing docks and pipelines to get these materials to markets. And then there are the really long-term projects -- like liquefied natural-gas terminals -- that will take decades to build, if they get built at all. Inflation storms in It's an extra dose of bad news that the Hurricane Katrina disaster -- and the damage still to be calculated from Rita -- will cut supply, in the case of oil and natural gas, and increase demand, in the case of cement and copper, in many of these already tight basic markets for basic materials. This hurricane season has been a major inflationary event at a time when the global economy could have done very well without one, thank you. And there is absolutely nothing that the Fed can do about this supply-led inflation. In fact, traditional inflation-fighting tools such as raising interest rates, to the extent that they make it harder and more expensive for companies to raise capital for these kinds of supply-increasing projects, may actually increase inflation. The Federal Reserve's inflation-fighting tools are designed to head off not just actual inflation, but inflationary expectations. The Fed believes, rightly in my opinion, that the true danger is psychological. Once consumers and businesses come to believe that future inflation is guaranteed, they will set off a self-reinforcing price spiral in which everyone raises prices now because they know prices will be going higher in the future and those current price increases then just buttress that belief in future inflation, leading to yet more price increases. Once these expectations have been created, it's very, very tough to reverse them. Paul Volcker's Fed had to resort to double-digit short-term interest rates and a deep recession to reverse the inflationary expectations of the 1970s and early 1980s, and to drive inflation down from 9% in 1980 to 3.2% in 1985. Usually the Fed can head off those expectations by demonstrating -- very publicly -- that it won't stand for inflation. The interest-rate increases by the Greenspan Fed are a kind of line drawn in the sand. Because people expect the Federal Reserve to do whatever is necessary, no matter how painful, to fight inflation, they don't expect future inflation. That's why the yield on the 10-year Treasury note has come down from 4.73% in June 2004 to 4.18% on Sept. 21. The financial markets expect the Federal Reserve to keep inflation in check. The wild card is Washington But there's a major source of inflationary expectations that isn't under the Federal Reserve's control. That source: the White House and the Congress. The sheer size of the annual budget deficit -- no matter whose accounting you use -- is damaging enough to any effort to prevent inflationary expectations from becoming embedded in the economy. As one spending plan gets piled on top of another, more and more people find it easier and easier to believe that the conscious plan in Washington is spend and spend, and then inflate and inflate, to make it easier to pay down the huge debt that's been built up. But I think the damage goes deeper than that. Watching our government at work, it's hard to believe that money, especially the U.S. dollar, has any value at all. Certainly the politicians don't behave as if it did. If money has value, how do you justify the recently passed transportation bill, filed with more than $30 billion in vanity projects designed to get politicians re-elected -- and the recent refusal by House Majority Leader Tom DeLay, R-Texas, to even consider giving back a dollar from that bill to pay for Hurricane Katrina? If dollars have value, how do you justify no-bid contracts for clean-up and rebuilding to politically connected companies, some of which have been under investigation for over-charging on no-bid contracts in Iraq? If dollars have value, how do you account for Congress recently upping the spending limit to $250,000 from the previous $15,000 on government-issued credit cards passed out to Federal Department of Homeland Security employees, even though no one knows how many cards have been issued and even though there seems to be no organized effort to make sure that government workers turn in their cards when they leave government employment? The best figures show some 500,000 cards were in circulation at the peak, but the number could be as high as 700,000. Think the Federal Reserve's measured interest-rate increases and the occasional warnings from Alan Greenspan are any match for the example of our national government, spending our money as if it was so worthless that there's no point in even keeping track of it? Washington, D.C. is one source of inflationary expectations that the Federal Reserve can't control. Updates Buy Ensco International Ensco International is a hurricane play, pure and simple. Drilling rigs were in short-supply before the big storms hit the Gulf of Mexico; they're in even shorter supply now. And short supply means higher day-rates for drilling companies that have rigs to hire. Ensco International is a buy on the timing of the contracts for its fleet of 43 jack-up rigs. Only 39% of its fleet is under contract through 2006. In times of weak demand, that would be a problem, because investors would be rightly worried about how many of those new rigs would wind up hired and at what rates. But with ocean drilling rigs in very short supply, the lack of contracts becomes a plus because it will allow Ensco International to sign 61% of its rigs to contracts at higher day rates. For example, the company recently signed a new contract at a day rate of $81,000, up from the mid-$50,000 range for the old contract. I'm adding the shares to Jubak's Picks with a March 2006 target price of $51 a share. I'd set a stop loss at $36.40. (Full disclosure: I own shares of Ensco International.) Buy Plum Creek Timber If the Federal Reserve has lost control of inflation, as I argue in my Sept. 23, 2005 column, then investors want to increase their exposure to hard-assets stocks. And very little is harder than timber and timberland. As Plum Creek Timber so clearly says on its Web site, the company's primary business is "to grow, harvest and sell timber." With timber demand soaring and timber prices climbing in the wake of hurricanes Katrina and Rita, that's not a bad business to be in. Before the storms, timber revenue climbed 17% in the first six months of 2005. But that doesn't mean this owner of 8 million acres can't also run a very lucrative real estate operation. The company owns more than 8 million acres of land. About 230,000 acres of that real estate is highly desirable land, suitable for development, near fast growing markets in Florida and Georgia. Morgan Stanley recently calculated that the company's real estate holdings were worth about $38 a share. Plum Creek Timber, which was spun off from Burlington Resources New developments on past columns 5 stocks in growth pockets Joy Global A golden way to play the dollar's fall Well, the gold markets are certainly acting like inflation has slipped out of the Federal Reserve's control. Gold recently climbed to $470 an ounce on a combination of increased demand for the commodity from jewelry makers and from investors looking to hedge inflation and other market risks. With turmoil in the energy markets and soaring energy prices as a driver, I expect gold to continue to appreciate in price as a risk hedge over the next 12 months. Goldcorp Will Katrina tip the U.S. into recession? In my Sept. 2, 2005 column, I argued that the longer Gulf Coast oil and natural gas production was shut down, the more damage Hurricane Katrina would do to the U.S. economy. As of Sept. 21, with Hurricane Rita bearing down on another segment of the oil and gas infrastructure that lines the Gulf Coast, the U.S. Minerals Management Service reported that 73% of the oil production and 47% of natural gas production in the Gulf of Mexico was still "shut-in" because of Katrina. The cumulative shut-in oil production for August 26 through Sept. 21 was 27 million barrels and the cumulative shut-in gas production was 125 billion cubic feet. According to Briefing.com, that compares to shut-in production of 12.9 million barrels of oil and 58 billion cubic feet of natural gas over the first 19-day period after Hurricane Ivan last year. As of Sept. 22, the Minerals Management Service was reporting that 74% of all manned oil and gas platforms and 65% of all drilling rigs currently operating in the Gulf of Mexico had been evacuated because of Hurricane Rita. 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 owned or controlled shares in the following equities mentioned in this column: Ensco International, Goldcorp, and Plum Creek Timber. He doesn't own short positions in any stock mentioned in this column. | |||||||||||||||||
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