The Oser View

Bahrain-Iran Jitters

US bond prices are rising and stocks are falling at this hour on "flight to quality" trading.  The rumor du jour is that the nuclear carrier USS Nimitz will head for the Persian Gulf on Monday as either a demonstration of strength for Iran's benefit or to assist in military action against Iran's nulcear facilities.  An even better rumor is said to emanate from Moscow: A US attack against Iran' s nuclear installations and code named "Operation Bite" is scheduled to begin at 4:00 a.m. on April 6. 

Good News on the Housing Front

Every picture tells a story and this chart of the month-to-month trend in existing home sales tells a very hopeful one.  These sales, which comprise 85% of all home purchases, are clearly on an uptrend after establishing a bottom in the second half of 2006.  February sales rose 3.9% to an annualized rate of 6.69 million units.  Sales increased in every region despite unusually bad weather in much of the country.  Both median and average sales prices rose as well, although they remain slightly lower than a year ago.

Clearly, lower prices are beginning to spur demand, and price isn’t the only factor.  As builders of new homes scale back to work off their inventories, supply is beginning to diminish. The monthly supply of existing homes for sales is still well above normal at 6.7 months, but it too is on the downswing from the peak of 7.4 months reached last fall. 

We are not in the clear yet, but each month’s data strengthens our view that the so-called “sub-prime meltdown” will have relatively little spillover impact on the larger economy.

Chart: Bloomberg News

But Who's Counting?

The Federal Open Market Committee, the Fed's policy arm, met today and left the fed funds rate unchanged at 5.25%.  A statement following the meeting used the word "moderate" three times, once as an adjective to describe the expected pace of economic expansion and twice as a verb to predict the trend of inflation.  Even more popular was the word "inflation," which appears four times in the brief statement.  Even though the most recent inflation statistics have been "somewhat elevated,"--which by the way is classic Fedspeak: Never be direct; always hedge your bets--inflation "seems likely" to taper off.  Nevertheless, the risk that it won't is still the Fed's predominant worry.  But, for now, they will wait and see, with "future policy adjustments" dependent on incoming inflation data.

The two most important words, though, were those that did not appear in the statement.  Saying that "the adjustment in the housing sector is ongoing" is a long way from expressing concern that the problems of many sub-prime mortgage companies will spread to the wider economy.  There is, as yet, little evidence of such a spillover and the Fed is right not to refer to it.  The other important word is "tightening."  In previous post-meeting statements, the Fed has consistently warned that future increases to the fed funds rate may be necessary.  This time they did not, an omission the financial markets are taking as an invitation to party.  Bond and stock prices are both rising, and fed funds futures are pricing in a fair probability of a rate cut as early as mid-year.

Steady As She Goes

Industrial production in factories, mines, and utilities jumped 1% in February, the biggest one-month gain since late 2005.  Exceptionally cold weather accounted for a 6.7% increase in the utility sector, but large percentage increases were also recorded in the production of motor vehicles, high tech equipment, and home electronics.  Plant capacity utilization increased to 82%.  This metric bottomed out below 74% in the 2001 recession and rose steadily until it peaked last summer at 82.4%.  It dropped below 82% through the fall and winter before picking up again in February. The Consumer Price Index increased 0.4% primarily because of higher energy and food costs.  Core CPI, which excludes food and energy, was up 0.2% for the month 2.7% on a year-over-year basis.  Clothing prices rose for the third consecutive month, and medical costs rose 0.5% following a 0.8% rise in January.

Every month-to-month data series contains little blips here and there, and today's data is no exception.  Yes, February was very cold and apparel costs jump around a lot.  But taken as a whole, today's numbers could hardly reinforce more clearly the Fed's basic position: The economy continues to grow at a moderate pace and inflation is a bit higher than it should be.   

An Evening with Alan Greenspan

Every year, over the Presidents’ Day holiday weekend, our friends at FTN Financial hold an investor conference at the historic old Peabody Hotel in Memphis.  Most of the attendees come from community banks like ShoreBank and the presentations are geared to our investment concerns.  FTN also invites top-quality outside speakers.  This year’s special guest was former Federal Reserve Chairman, Alan Greenspan, but instead of prepared remarks, Mr Greenspan answered questions submitted by the audience and FTN’s economist, Chris Low.  Mr Greenspan’s broad knowledge of economic issues, his detailed recall of even the most obscure statistics, and his unrivaled experience combined to make the evening fascinating.  Below, in as close an approximation to his own words as my hasty note-taking could get, are his opinions.

On credit scoring to make loan decisions: “Credit scoring is simulating small bank practices, but not done as well.”

On the long-term effects of government entitlements: “There is a 25-50% probability that the US has over-committed benefits—particularly Medicare—that the government may not be able to deliver.”
 
On liquidity: “Liquidity is the critical question for evaluating finance today.  Liquidity is the market value of all claims against real assets.  The market value of assets has risen faster than GDP over the last 20 years. The long-term decline in real interest rates is driving up the market value of assets.  The problem is that someday it will turn around because the vast proportion of all market value is in our heads.  Optimism creates something real.  It will evaporate when you least expect it.  It is always the unexpected that gets you.  To this day, I don’t have a clear idea why the Crash of October 1987 happened.”

On the reasons the Fed dropped the fed funds rate to 1% in 2003:  “You cannot have deflation with a fiat currency (i), so the Japanese deflation was a surprise.  We specifically lowered rates in 2003, even though it wasn’t necessary, to avoid corrosive deflation like in Japan.  In fact, the expected forecast was right and taking fed funds to 1% was an insurance payment.” 

On the reason the Treasury yield curve is inverted: “Who is buying the 30-year Treasury bond?  There is a higher risk premium out there than people know.  Technical factors are driving prices up for the long stuff, not fundamentals.” 

On the prospects for achieving energy independence: “Nebraska will be importing corn to provide ethanol.  It’s a special case that is over-hyped.  The whole crop only gives 4-5 million barrels per day out of 22 million we consume, besides the pigs would starve.  Cellulose ethanol has more potential without touching feed grains.  There are really positive possibilities to offset oil. We produce 150 bushels per acre today compared to 25 bushels in the 1940s.”

On the real value of the American economy: “Here are the metrics to focus on in the next decade.  The conceptualization of our GDP, if we actually endeavored to weigh inputs and outputs into the production process, actual tonnage is growing by ½ of 1% a year.  The rest of it is ideas.  It’s no longer physical labor that matters.  Today it’s intellectual labor that matters.  We have to pick up the skills of the American workforce.  One of the critical factors molding GDP will be intellectual property rights.  They will be difficult to enforce and define.”

On the need for political independence in monetary policy: “Monetary policy should be put aside from the normal political process.  This was decided by Congress in 1913.(ii)  Certain types of activities should not be determined by majority vote.  It’s like telling a heart surgeon where to cut.  Monetary policy is of this type.  It is basically professional.  I don’t recall a single Congressman who ever said to me, ‘Raise interest rates!’  If it were up to them, interest rates would always be zero.”

On the reliability of the inverted yield curve as a predictor of recession:  “The yield curve is no longer as predictive as it used to be. In the 70s and 80s, the correlation was very high, but not anymore.  It used to work because rising short-term rates was an indicator of a credit crunch.  Lower long rates today are due to a global disinflationary effect.”
      
On the argument against rules-based management of monetary policy:  “Monetary policy is an extension of business forecasting.  The point is anything that enables us to forecast the economy better, allows us to make monetary policy better.  There is no replacement for trying to pierce the thick fog of the future, regardless of the tools we have.”

On the relationship between low unemployment and inflation: “Unemployment was under 4% in the late 90s, but rising productivity prevented inflation.  The Phillips curve (iii) was useful until the stagflation of the 70s.  People still use it as an explanatory vehicle.”

On factors affecting the price of oil: “The price of oil is now around $55-60/bbl.  What determines its price?  We have reduced oil intensity by half since the 70s.  It still is at levels where it has monumental effects.  The price issue is tricky, because it is no longer supply versus consumption, because reserves have been rising with consumption, but profits are going back into the oil business.  Capacity to produce is not rising as fast as reserve growth.  Hedge funds are bidding inventories away from refineries.  A huge demand for inventories is held in escrow for the financial community.  Hedge funds are driving up the price.  Reduced consumption is a very good thing.  Our problems would be worse without it.”

Mr Greenspan’s most revealing comments are his definition of credit scoring and his defense of the Fed’s highly accommodative policy in the later years of his reign.  “Credit scoring is simulating small bank practices, but not done as well.”  No one yet knows the severity of the sub-prime mortgage meltdown.  Predictions range from minor and contained to catastrophic and far-reaching.  But one thing is pretty clear.  Most problem sub-prime mortgages were made by volume shops relying on models to determine creditworthiness, not by old-fashioned character lenders who might relax credit standards on a case-by-case basis for borrowers they took the time to know.  If the sub-prime meltdown produces widespread fallout, Mr Greenspan’s aphorism may require emendation: “Credit scoring is simulating small bank practices, but not done well at all.” 

More troubling, but in a different way is the confession that the 1% fed funds target rate—in effect for a full year, from June 2003 to June 2004—was merely “an insurance payment,” that it “wasn’t necessary,” and that the Federal Open Market Committee acted against the advice of the Federal Reserve staff.  The financial consequences of mistaken monetary policy are enormous.  In ordinary language, making an insurance payment is benign and reasonable.  Few people truly begrudge paying a tiny fraction of their home’s worth to protect its value.  But bond investors have paid a very steep price for the Fed’s insurance payment against a highly unlikely deflationary event, and society as a whole may have to ante up soon. 

The bond markets never quite believed the doomsday deflation scenario, which is why long-term rates were so much higher than the fed funds rate from 2003 through 2005.  Still, the Fed’s ultra-accommodative stance kept all rates lower, and therefore prices higher, than they might otherwise have been.  In the reaction that inevitably followed, virtually all bond portfolios lost value, and many investors have had to realize significant losses.  Worse still, low interest rates were an enabler and major contributor to the explosive growth of sub-prime mortgages.  It may yet turn out that the last major decision of the Greenspan Fed was its worst. 

Notes: (i) Fiat currencies, which every country issues today, are legal tender simply because the government says so.  Countries with fiat currencies are deemed to be immune from inflation because the government can print more money whenever it wants.  The opposite is a currency redeemable in gold and/or silver.  (ii) When the Federal Reerve Act was passed.  (iii) The Phillips curve attempts to quantify an inverse relationship between unemployment and inflation; that is, high unemployment drives down inflation becuase fewer people have money to spend.  This is a common sense notion, but one that's better suited to a laissez-faire industrial economy where large numbers of unskilled worker can be hired and fired at will  Today, as Greenspan notes, the globalization of labor and trade have undermined the predictive power of the Phillips curve. 

The Employment Picture

The Labor Department reported that the economy added 97,000 new jobs in February, in line with economists' expectations.  As has become the pattern, prior months' job gains were revised substantially higher, so we should expect the same with today's number.  The construction sector lost 62,000 jobs.  It was hit hard by the combination of unusually cold weather and the housing slowdown.  The underlying message, though, is how little problems in the housing industry--and for that matter, manufacturing as well--are effecting the broader economy.  Service producing jobs were up 168,000 with strong growth in education, leisure industries, information and finance.  Average hourly earnings increased 0.4% to $17.16 for non-supervisory works and the unemployment rate dipped to 4.5%.

As I write, the bond market is selling off sharply.  Today's data pushes the long-deferred hope of an ease in the fed funds rate back to August or September at the earliest.