May 07, 2004

This Foe is Beyond You, Mr. Magoo

Does the Fed really look at wages when deciding whether to raise rates? History suggests it does. The below from Greg Weldon today on the very issue. The issue is the role of final (consumer) demand on inflation. Without final demand...inflation can't really heat up (at least that appeared to be true until China came into play.) The Fed may find itself in a bizarre new world--unable to contain inflation caused by Chinese demand for raw materials...and unable to reverse wage deflation...caused by Chinese supply of cheap labor. Of course I shouldn't hang it all on the Chinese. And these adverse side effects (from the American wage earner's perspective) are the natural results of free markets. What the Fed, and investors, appear to have missed in all this is that monetary policy alone can't solve this problem. As Gandalf said about the Balrog in the mines of Moria, "This foe is beyond any of you. Run!" To the extent that disinflating wages are a national problem...they would require a larger strategic approach. Manipulating interest rates, to use the military metaphor, is simply a tactic. A Grand Strategy, like the one I've suggested the Chinese are pursuing, would start with a simple question: Is it possible to form a national economic policy that guarantees Americans a certain standard of living? That's an ambitious question, of course. And up to now, free market intellectuals have been inclined to say that the freer the trade, the greater the prosperity. Could be. But the truth is, none of us has ever really lived through a period where labor and capital move as freely as they do today. Could the idea that the mobility of labor and capital leads irresistibly to greater prosperity be just naive American faith in free markets? After all, free markets are competitive. They don't benignly bestow affluence on everyone. True, they tend to produce better goods and services at lower prices. Competition, as Hayek once said, is decentralized planning. That is, competition is the result of planning by numerous individuals...plans to compete, to save, to invest, to take risk prudently. The more competitive a marketplace the greater the quantity and quality of goods, and the cheaper the price. I'm inclined to say that rather than adopting a national Grand Strategy of competition between nation states (didn't work so well in 1914...why would it work any better now), Americans are better off getting back to competing harder in the free market. Not that that will be easy. To compete, you have to have an advantage. And right now, it's hard to see what kind of competitive advantage the American economy has. Education? Cost of labor? High savings rate? Technological savvy? Moxy? Dynamism? The language? Rather than thinking about the economy as a whole, why not think about things closer to home first? We think in terms of national and political solutions these days. Everything in our culture encourages to think about social solutions. All problems become political problems and seemingly demand a political solution. Does anyone take seriously Adam Smith's idea that by pursuing your own ends--and not presuming to know what's best for the world--you indirectly, through the invisible hand, improve the lot of your neighbor? Do you believe that? I still do. Which is why I think the best solution to America's competitive problem is being fiscally responsible for yourself, your family, and your friends. That means not going broke in the stock market, getting blindsided by a panic in the housing market, or tied to the mast of the dollar as the ship sinks. And even if I'm wrong about the big risks in the economy, being an investor in a globalized world means you still have a lot of opportunities to stay well ahead of the storm. In the meantime...I'll post the non-farm payrolls report when it comes out. But here are the straight facts on Fed rate increases and wage growth from Weldon. The important point: the Fed doesn't historically tighten until wages pick up and capacity utilization increases. If history holds, the Fed won't raise until those two things change. "We note the following macro-details as apply to the averages noted in past period linked to phases where the Fed BEGINS to tighten monetary policy (nine occasions since 1967). *`Average year-year change in Average Hourly Earnings when Fed begins tightening -- +5.0% ---- versus the Current Rate of +1.8%, which is LESS than HALF the average, and far below the +3.9% rate seen before the last tightening, in1999. * Average year-year change in Total Wages and Salaries when Fed begins tightening, +7.5%, or THREE TIMES the Current rate of +2.5% yr-yr. * Average year-year Payroll growth prior to Fed tightening-- +3.03% * versus the Current rate of NEGATIVE (-) 1.48% yr-yr. "Payrolls NEED to SURGE by an even greater degree, just to be brought up to a speed consistent with a tightening monetary policy, to the tune of 300,000 per month. "MOREOVER and FAR MORE PROBLEMATIC, payroll expansion would NEED to be strong enough to LIFT Earnings and Wages by a LARGE degree, before the income dynamic comes anywhere close to offering support for a tightening monetary policy. "And STILL, THEN, given the HUGE gains in Productivity, it would take an even greater degree of final demand strength, to even begin pushing the US output juggernaut towards capacity constraints. Note the following: * Average Capacity Utilization Rate when Fed begins tightening (again, nine episodes since 1967) 82.2%. * Capacity Utilization Rate when Fed LAST began tightening, 82.3%, seen in the 1999 episode. * LOWEST Capacity Utilization Rate when Fed has started tightening, 79.1%, seen twice, in May-1976, and April-1986. * Current Capacity Utilization Rate, 76.5% "The data speaks for itself, and does so LOUDLY." Yes indeed it does, Greg. Lacking huge payroll and wage growth, plus tightening the slack in cap u, the case for the Fed raising interest rates ain't there, historically speaking. For stocks, this is bad news. It means the market will continue to think the Fed is behind the curve and ought to be raising rates anyway. Our S&P and OEF positions should fit the bill nicely.

Mawkish Investing

A note from Lord Rees Mogg over in London....always on the lookout for long-term investment strategies. Strategic Insider – 6 May 2004 – William Rees-Mogg In the 1950s, when I was first working in London, Ambassador Jock Whitney was the U.S. Envoy in London. He was a Republican and he represented President Eisenhower. He had quite a difficult time; though he was personally popular,and what used to be called “a fine figure of a man”, he had to reconcile British opinion to Eisenhower's decision to undercut British policy at the time of the Suez crisis. The United States was felt to have let her ally down with a bump. I did not know the Ambassador, but I heard him address a number of public dinners. I later read that he had bought the New York Herald Tribune, which was a Republican newspaper which competed with The New York Times, always a New York liberal newspaper. The old Herald-Trib was an excellent newspaper,but a money-loser. The Ambassador had to close it,and he merged its overseas edition with The New York Times. That newspaper still survives, but in Times’ ownership, and is widely read by Americans in Paris and London. Apart from his newspaper operations, I did not hear much more about him until a few days ago. He came back into the news when his estate sold Picasso’s portrait of a boy with a pipe, a charming, if somewhat sentimental painting from Picasso’s figurative period before the First World War. I suppose that it is a masterpiece, though if anyone were to describe it as “mawkish”,I should know what they meant. It was for sale at Sotheby’s, and went for more than $100 million, including the buyer’s premium. It is the first painting ever to be sold for more than $100 million,which is still a very respectable sum of money,enough to endow a College, though Harvard’s endowments run into tens of billions. At any rate, $100 million would endow a small liberal arts College in the Midwest, if that was what one wanted to do, and would finance a run for the Senate, if not for the Presidency. Apparently the Ambassador bought the painting for $30,000 in 1950. That did give me a tinge of regret. I did not have $30,000 in 1950 – it was then a far bigger sum than it is now,but I paid about $10,000 for my first house in 1952, so I could have raised enough money to buy a less highly rated Picasso. I like the idea of long term investment. The Whitneys turned $30,000 into $100 million in 54 years. By my calculation that means that the investment doubled nearly twelve times in the period. That may not be as extraordinary as it sounds. If my sums are right, the Picasso had to double every four and a half years. A compound investment at 15 per cent will achieve that. In any case, this was a nominal, not a real, gain. I am not sure how much the dollar depreciated between 1950 and 2004,but it must have been of the order of a 90 per cent depreciation. That means that $30,000 became $10 million in real terms. In real terms the Picasso only doubled ten times, which is only about a 12.5 per cent real return. Pretty good, but no better than some stock market investors, including, I suspect, Mr. Warren Buffett. Paintings are not a short cut to becoming a billionaire. It is a help, of course, if, like the Whitney family, one is up in the dollar stratosphere to start with. As for me, I hope I have got my compound interest sums right.

Fannie tries restating, and clearing up the rate confusion

The problem with owning an asset that's actually someone else's promise to pay is that…well sometimes they don't. According to an article in today's Wall Street Journal, Fannie Mae may be forced by its regulator to restate earnings—to the tune of $500 million—because of higher loan defaults that it has so far reported. The Journal article says, "The order affects Fannie's $8 billion portfolio of securities backed by manufactured-housing loans, as well as $300 million of securities backed by aircraft leases. The manufactured-housing securities have deteriorated in quality because of a surge of defaults by buyers of mobile homes in recent years. Fannie so far has made write-downs on the manufactured-housing securities totaling about $217 million, but some analysts argue that much bigger write-downs would be in order, based on actions taken by holders of similar securities." Manufactured housing loans…securities backed by aircraft leases…what’s next? Single family homes? In the meantime, let me clarify what I've been saying about interest rates. First I say the Fed can't raise rates. Then in the housing report, I say interest rates are almost certain to rise. Am I saying two different things? Nope. The Fed controls short term interest rates, not long-term rates. For example, the average rate on a 30-year fixed mortgage is 6.12%...the highest level in 8 months. It's risen seven straight weeks. The bond market can move long-term rates up no matter what the Fed does. And it's been doing just that. This is the bond market telling the Fed it sees inflation in producer and wholesale prices...and that it wants the Fed to raise the Fed funds rate. The bond market yells. The fed shuts its ears. Long term rates go higher. Can the bond market force the Fed's to raise short term rates? No. It can make the Fed look foolish and out of touch. It can drive yields even higher. But the Fed need not react. First, the inflationary pressure in commodity prices is coming from Chinese consumption of raw materials...not overheating U.S. consumers (there is a whole other species of inflation in the health care, education, and other services...but I'm not sure what the source of that is...I'd say the cost of government regulation and insurance premiums being passed on to consumers...or just a bubble in the perceived value of higher education). Can the Fed make a token gesture and raise 25 basis points and say something banal before the election like, "The economic recovery continues to pick up pace and appears to be self-sustaining, while growth in the labor market seems to have turned the corner. Though the risks between inflation and deflation remain roughly balanced, the committee believes a modest increase in the funds rate will hold inflationary pressures in check without impeding economic growth." Sure. But will the bond market buy it? We'll see. But as I've said before, the Fed hasn't caused inflation in consumer incomes...and without's going to be awfully hard to raise short term rates meaningfully without doing even more damage to the consumer. In other words, the Fed is increasingly irrelevant...U.S. monetary policy is controlled in China and Japan now

Quote of the Day: Googletop?

From the folks at Options Edge... "...stocks are expensive and speculative fever is high. Barron’s "Big Money" poll in the latest issue shows 61% of the professionals interviewed to be "bullish" or "very bullish." As indicated in the same article, the track record of these professionals is not something to hang your hat on. Could the much-anticipated Google IPO mark the high much the same way the massive AOL / Time Warner merger did at the turn of this century? Only time will tell… "

May 05, 2004

Wages and Inflation: Charts of the Day

Dear Reader, back from the wildnerness and back on the blog beat. Let's hope I'll have less trouble staying in touch from Asia than I did in America. Quite a bit has happened since I last wrote to you. But instead of reviewing what has happened, let me first bring your attention to what's about to happen. The non-farm payrolls report comes out on Friday. Recall that it was the March report, with it's gain of 308,000 jobs, that sent the market into a tizzy and raised the specter of a rate hike by the Fed. Since then, the Fed has stood pat (evidence yesterday's meeting). But the bond market has pushed long-rates up. And the entire reflation rally that began last year ended quite suddenly. It was an equal opportunity distribution of punishment. No sector or asset class was spared. Such is the nature of the end of bubbles. And it's not over yet. But I do think we'll begin to see a divergence in asset classes, with commodities and precious metals finding some stability, while equities in general get rocked. I've written more about that in my weekly SI report. In this space, a couple of images that bring home the Fed's big problem and it's bigger failure. First is the average work week. You can see that it's been in a downward trend since 1998. Is this just workers being more productive in less time? Or the fact that there are more part time and retail trade jobs in the economy? I think it's the latter. More jobs but at lower wages and fewer hours. The next chart is the smoking-gun of the current economic crime scene. It shows average hourly wages not keeping up with inflation. This is the error in the Fed's strategic thinking, that wholesale and producer price increases can be passed on to a consumer who's wages are growing, on average, at less than the rate of inflation.