Tuesday, June 06, 2006

The 5.25% Solution -- Fed done in June?

Ever since the Volcker era took hold, the Street sees the Fed driving the funds rate too high and about to crater the economy -- well before the Fed. They have been right a few times. This isn't one of them.

Current worries have been in vogue since at least last year, when Fed funds passed 3%. The market's predisposition has been to price in one or two more tightenings and then done and then -- when's the first ease? This pattern is like a loadstone -- no matter what happens or what the Fed says. Why? The market was convinced that the economy would slow as consumers were hurt as housing collapsed under the weight of higher mortgage rates and $40 oil. The Fed's forecast was better than the street's. Looking forward, it still is.

The market and its gurus got really worried the other week on the heels of weaker-than-expected employment data. Enough so, that the Fed had to set every one straight, again. They let us know that 100,000 new hires a month is probably right for an economy growing at 3%, and that while the economy might be moderating to where they want, the magic low 3s, there isn't much slack and inflation continues to edge up and, lo and behold, inflation expectations are moving up as well. They even trotted Greenspan out to let every one know that high oil prices haven't dampened growth. The Street seems convinced that 5.25% funds plus $70 oil means an ease beginning next week (check out the euro$ strip, its all there in black and white, black and amber(?) if you are looking at a Bloomberg).

What does it mean? Fed goes in June (every one knows that), but the opportunity is that the market believes they won't go in August. Price of Augy funds suggests no way for it to go up unless Fed eases and for it to drop almost 20 ticks if the Fed tightens -- all assuming Fed tightens 25 on June 29.

From my perspective, the Fed reaction to the employment data means it is more likely to go in August than not. Economy is fine, money is cheap, credit is plentiful, and the weaker dollar is helping capex. Stock market is probably more worried about inflation, adjusting p/e accordingly, than it is worrying about weaker profits. On the other hand, hey I am an economist and this is why no bet is certain, Fed needs growth and asset inflation. There is no rational reason for them to put the brakes on the economy.

Inflation, over time, will increasingly become a problem. All these past years of all the central banks pumping liquidity into the system! At some point, financial assets are swapped into physical goods and with a vengance. Its begun, and its only the beginning. Quite a spot Mr. Greenspan left for Mr. Bernanke. In the meantime, 50/50 for August and lets stop looking for the big slow down -- it is a long way off.


Anonymous said...

The most rational analysis I've seen in Blogland yet....

Where have you been??

Steve Blitz said...

thanks for the comment, trying to build a readership, would appreciate your letting people know..