The Fed's monetary policy dilemma (page 1 of 2)

We have pointed out before that the year 2003 was unusual in the sense that every asset class including bonds, stocks, real estate, and commodities went up in price.

Then, we had after February/March of this year all asset classes - except for real estate - declining in price and, now, since mid May, we have all asset classes including stocks, real estate and commodities, but excluding bonds and the US dollar, moving up in price again - this largely as a result of a massive monetary expansion engineered by Mr. Greenspan.

I am mentioning this because it is for the American Federal Reserve possible to increase the money supply exponentially (in the last four weeks at an annual rate of more than 20%) and keep US interest rates significantly below the rate of inflation. But by 'printing' too much money the Fed pushes also the US dollar down and creates eventually higher inflation rates, which will one day in future also drive interest rates much higher.

In fact, whereas, as can be seen from the above figure, the Fed fund rate is currently at 1%, it should be today - based on nominal GDP growth and recent inflation - at least at 3% to 4% (fed watchers say the Fed is 'way beyond the curve'). In fact, if you look at the spread between the T-Bill Rate and the 30-Year T-Bond Yield, the spread is at its widest level in the last 70 years indicating that short-term rates are far too low at this point of the business cycle, and also given the housing and energy price induced inflation we have at present.

Therefore, Mr. Greenspan has come to a dead end street with his monetary policy. Despite ultra easy monetary policies the bond market has tumbled since March of this year with the result that the housing refinancing index has also collapsed to the lowest level since May 2002.

This by itself may have some negative implications for US consumption in the next few months, as refinancing activity allowed homeowners to withdraw equity from their homes, which was then largely spent on consumer goods and equity purchases. In fact, it will be interesting to see whether the recent strong employment gains (at least statistically and superficially interpreted) will be able to offset lower home equity withdrawals by homeowners.

My opinion is that this is unlikely to be the case, and that consumption will slow down in the next few months - also because financial market investors have failed so far this year to make any money and are already likely to sit on some losses, as they positioned themselves in asset inflation plays such as copper, steel, shipping and housing stocks, all of which are already down from their March highs by 30% or more.

Now, Mr. Greenspan has two options. Either he does pursue his policy of keeping short-term interest rates artificially low, or increases them in baby steps of just 0.25% increments and at a slow pace, or he takes some more drastic tightening moves action and increases short-term rates in 0.50% increments right away.

In the first case, the bond market will continue to drift lower, as inflation will suddenly accelerate meaningfully and in the process also drive down the dollar.

Alternatively, he drives interest rates up significantly, but then stocks, and home prices will ease and have a negative impact on consumption, while bond prices and the dollar should be in a position to rebound. In short, I am mentioning this because unlike what we experienced in 2003, when all asset classes including stocks, commodities, real estate and bonds rose in concert, we are beginning to see, in 2004, diverging performances of asset markets.