The Smart Profits Report: Issue #430
Monday, June 18, 2007 Current Interest Rates: The Inflation Numbers Are Out… Here’s The Bullish And Bearish Spin
By Martin Denholm
Managing Editor, Mt. Vernon Research Let me see… how shall I spin this news? If I were a perma-bull, I’d probably say something like this: "Well, that was pretty tame, huh?" But if I were a perma-bear, I’d have an entirely different take on the news. Something like this… "Curses to those perma-bulls and their rosy glasses! If inflation is so “tame,” then why do I have less money?" Today’s Consumer Price Index (CPI), a key gauge of U.S. inflation levels, added more weight to the theory that inflation is well contained. The so-called “core” inflation rate – which excludes volatile energy and food prices – edged up a paltry 0.1% in May. Over the past three months, the core rate has risen at a mere 1.6% annualized rate, and 2.2% over the past year – close to the Fed’s target level of current interest rates. In addition, the “core” Producer Price Index (PPI) number, which was released on Thursday, showed the first increase in three months – and even then, by just 0.2%. Looking Beyond The Bullish Spin “Consumer prices show 2nd largest gain in 16 years,” blared the headline on MarketWatch this morning. While the ever-giddy market latched onto the tepid core inflation rate and zoomed off to the races today, there’s another side of the coin. The overall CPI was up 0.7% in May – the biggest monthly rise in almost two years – due to a 10.5% jump in gasoline costs and 5.4% increase in energy prices. And that’s not all… Thursday’s Producer Price Index (PPI), which measures production prices, as opposed to retail prices, also showed a nasty inflationary spike. Led by a 10.2% surge in wholesale gasoline prices and a 4.1% climb for energy prices, the biggest in six months, the overall PPI rose 0.9%. While the latest inflation readings didn’t surprise anyone, it parks the Fed squarely on the fence. For a group that is on record as saying it’s more concerned about rising inflation than slowing GDP growth, this number puts them in a tricky situation. So let’s see what the bankers are thinking… Fed Slaps On A Lovely Shade Of Beige On Wednesday, June 13, 2007, the Federal Reserve released its latest “Beige Book” report, which provides an economic rundown of all 12 U.S. regions and serves as a guideline for upcoming monetary policy meetings. Overall, it reported that the country continues to grow at a steady, moderate pace, with consumer spending and manufacturing faring well and helping to offset a sluggish real estate market. But what effect will this, plus the latest inflation news, have on Fed policy from here? Bill Vs. Ben: Talking About Current Interest Rates In my English homeland, there used to be a cute children’s TV show called, “Bill And Ben: The Flowerpot Men.” The show was basically about the daily lives and adventures of two little guys who live in flowerpots next to each other and chat (a neat idea, but don’t ask me what the creator was smoking when he/she came up with it!) Now, I’m not saying Ben Bernanke and Bill Gross are stuck in flowerpots. But they’re certainly talking about current interest rates. In the red “Reserve” corner… armed with a wad of paper that could kill a rainforest… the “Beard Of The Beltway,” Fed chairman Ben Bernanke. In the blue “bond” corner… one of the most successful and highly respected money managers in the world, responsible for investing $700 billion for his PIMCO bond clients… PIMCO bond fund chief Bill Gross. Let’s turn to Bernanke first… A Summer Snooze For The Fed Head With the economy hitting the skids during the first quarter (a measly 0.6% GDP growth rate – the lowest in four years), you may have heard speculation that the Fed would be forced to cut interest rates – even with energy inflation spiking – in order to kick-start the economy. Of course, doing so could also trigger a vicious cycle, where higher growth breeds higher inflation. But in saying that “core inflation seems likely to moderate gradually over time” and that the economy will shake off housing woes and “advance at a moderate pace, close to or slightly below the economy’s trend rate of expansion,” Bernanke seems comfortable with current interest rates at 5.25% – just where they’ve been for the past year. Those comments virtually end the chance of a shift in monetary policy before the end of the year. In fact, Goldman Sachs now says the Fed won’t cut interest rates in 2007 or 2008. That’s a pretty bold prediction, given already slowing economic growth, high energy and gasoline prices that could curb consumer spending, and a weak real estate market. Merrill Lynch is also pessimistic about interest rate cuts. A Bull On The Loose At Goldman... But Not In Corporate America And there must be a herd of bulls running around at Goldman Sachs, because the firm has also revised its second and third quarter U.S. GDP growth estimates from 2% in both quarters to 3% and 2.5% respectively. The White House Council of Economic Advisors (which Bernanke used to run), the Office of Management and Budget, and the Treasury also recently said that GDP growth will strengthen this year and power its way to 3.1% in 2008 and 2009. But the nation’s CFOs aren’t so chipper. The latest CFO Business Outlook Survey has corporate number-crunchers feeling gloomy about economic growth. They cite a bevy of reasons: - Tepid economic growth
- Weaker corporate earnings growth expectations
- Less hiring and capital spending (from 6.7% growth in the last quarter to 5.2% over the next year)
- Rising labor costs
- And weak consumer demand (due to higher inflation and weak housing market).
The only bright spot is the continued frantic pace of Merger & Acquisition deals – a topic I wrote about here two weeks ago. But while the Fed, Goldman Sachs and Merrill Lynch have scrapped the chances of an interest rate cut, Bill Gross has different ideas… This Market Is Nuts… And I Want A Rate Cut As a bond fund manager, Gross would like to see lower current interest rates, as that would kick up bond prices. So it’s no surprise to see him call for a rate cut in what he calls a “schizophrenic” market. According to Bloomberg, Gross says the Fed will keep interest rates at 5.25% for now. But he also says that when the “housing bust” and weak economic growth eventually drops inflation below the Fed’s 2% target level, it may lower interest rates in six months. That’s a fair argument. But it’s one that has affected Gross negatively this year. While his Total Return Fund has only declined 0.35% this year, it’s lower than 86% of its comparable competitors, because almost half its assets mature in one year or less – based on Gross’s belief that the Fed will lower interest rates. So what do we have here? Ben Bernanke has kicked off his shoes and hunkered down for the summer – the Fed is comfortable with current interest rates where they are right now. Goldman Sachs and Merrill Lynch are so comfortable, they’re almost horizontal, having scrapped any chance of an interest rate cut this year or next. Goldman and the White House are roaring like bulls, with their GDP growth projections. Corporate CFOs are painting a bleak picture. And poor old Bill Gross just wants an interest rate cut to help his ailing bonds! I don’t think the Fed will do anything with current interest rates for as long as it can get away with it. The bankers are hoping the situation will sort itself out – inflation will drift lower, consumers will keep spending, economic growth will rebound, the housing market will shore up. But remember, one or two awful economic reports, or external shocks like a geopolitical crisis, terrorist attack, or a hurricane that hits the oil and natural gas markets… and the situation could change pretty quickly. Good Trading, Martin Denholm Today's Smart Profits Action Center - While the Fed probably won’t touch interest rates when it meets to discuss monetary policy in two weeks, there’s no doubt that investors pay very close attention to the announcements to see what the bankers say about the current economic climate and gauge its potential future moves. You should, too. And my colleague D.R. Barton, Jr. wrote all about it in Smart Profits Report #391, Federal Reserve Interest Rates: How To Prepare For A Potential Price Shock.
- And for more on Fed chairman Ben Bernanke, make sure you check out this recent column from our sister publication, Investment U, Fed Chairman Ben Bernanke: How To Profit from the Fed's Current Policy...
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