Thursday, March 15, 2007

Why The Fed Won’t Lower Rates Just Yet

The chant for the Fed to lower rates is far more complicated than many investors either appreciate or are willing to admit. Today’s contribution to a stagflationary outlook for the US (PPI data) is one dynamic. It may not be the 1970’s, but slowing growth plus above acceptable levels of inflation = stagflation.

A second component is the conundrum that any one central bank has to deal with in a globalized economy. As noted in previous weekly reports, Martin Wolf has highlighted this issue quite clearly in his brilliant January 30th, 2007 commentary, “A divided world of economic success and political turmoil”. Another way to see this nation-state versus globalization issue is to consider the Bank of Japan and its recent rate decision.

Does the BOJ emphasize its national needs and help its domestic economy by keeping rates unchanged? Or does it acknowledge the global implications of the Yen carry trade and raise rates? The recent decision by the BOJ was to opt for the later. Future decisions will be most informative. I think you see the dilemma a domestic central banker has. Domestic needs versus global considerations.

A third piece of the equation deals with excess liquidity and unregulated money. I think Mohamed El-Erian, President and CEO, Harvard Management Company, said it quite well in his current interview with the Financial Times:

“I think that if this were normal conditions, the Fed would be looking to cut rates. The economy is slowing. The housing market is under pressure. The corporate sector is not spending. However I think that policy makers are increasingly aware of the source of endogenous liquidity, the liquidity that the market itself creates. Private equity is a perfect example, where a dollar that comes out of the public market, becomes $4 or $5 when it goes back in, through the private equity mechanism. So, I think that policy makers will wait for unambiguous evidence that the economy is slowing, before they move, lest they contribute to excess liquidity.”

Note: There is a related dimension to the Fed that I will touch on in a future commentary – the strong faith of many investors in the Fed’s ability to come to the rescue in times of crisis.

Investment Strategy Implications

Wait and see will be the operative policy for the Fed. Which, by the way, should be accompanied by higher long-term rates.

No comments: