THE FED’S OWN IRRATIONAL EXUBERANCE

Having for the most part enjoyed fawning praise from Wall Street and the business community during almost of all his 17-year tenure at the helm of the Federal Reserve, it’s understandable that Chairman Alan Greenspan believes his own press, sometimes, delusionally so, as may be the case once more.  The trouble is, some of his admirers-together with consumers, growing numbers of investor and a vocal minority among economists-are wondering a new whether the man who in early 1973 (while serving as then-president Ford’s top economist) said he was unabashedly bullish on both stocks and the economy could have it just as wrong now.

            Lest you’ve forgotten, that particular call proved one of the greatest contrary indicators of all time, with stocks eventually suffering their worst drubbing since the Great Depression.

            Unmoved by what soaring oil prices did to his 1973 prognostication, Greenspan and his fellow

Fed governors insist that the economy is regaining “traction” following its lull.  The job market is also improving, they say; this is something Senator Kerry is bound to take issue with when he and President Bush hold their second debate next Friday evening. Why, if it were not for oil prices putting a bit of a damper on things (such as corporate profits and consumers’ already-stretched budgets, to name just two of them) the economy’s growth would be positively breathtaking.

            On the surface, the Fed has had at least some good news on which to hang its hat.  The final figure for second quarter economic growth was recently revised to 3.3%, up from 2.8%; not sizzling by any means, but hardly the hamburger of doom.  Further,

government’s published inflation numbers have become downright tame of late.  As measured by the core personal consumption expenditure deflator, U.S. consumer prices were flat in July and August after rising at about a 3.5% annualized slip in the first half.  And this is in spite of the price of a barrel of crude oil rising to new nominal highs over $50.00 each.

            So what we have here is-much like a good part of the 1990’s-solid economic growth with little inflation.  That’s the Fed’s story, and Greenspan is sticking to it.  So infections is The Maestro’s optimism, in fact, that he has his entire board on board with the notion that the federal funds rate will ultimately reach the 3-5% area; a prospect which briefly spooked the bond market (more on it in due course) when that was made know a week ago via the release of minutes from August’s F.O.M.C. meeting.

            The summary of those deliberations which gave us the second of this round’s quarter-point rate hikes showed that Fed officials were in unanimous agreement that “significant” increases in short-term interest rates still lie ahead.   Stressing-as it did again when raising rates once more to 1.75% on the federal funds rate this past month-that it still views its policy as accommodative, the Fed summary said, “Given the current low level of short-term interest rates, especially when judged against the recent level of inflation, members noted that significant cumulative policy tightening would be needed to foster conditions consistent with the committee’s objectives”.  Nevertheless, the central bank once again assured us that we would get to the ultimate objective of a purportedly “neutral” rate at a “measured” pace.

            Maybe the Fed really believes in its bullish picture of a steadily growing economy that might rocket ahead even faster if we ever get a break in energy prices for more than five minutes.  Perhaps Greenspan and the gang really are trying to use a steadily tightening monetary policy in order that the Fed itself can subdue oil’s rise; something I warned in the August issue it would do at its peril.  Maybe the Fed doesn’t know what to think, and can merely try and talk positively enough to hopefully, keep us all at least docile-if not mildly exuberant with them. 

            Whatever the case, many take issue with the Fed’s Polly-annish outlook.  It’s true, for instance, that manufacturing output rebounded nicely in the summer months; by 0.9% and 0.5% in July and August, respectively.  Yet, as CBSMarketwatch.com’s Dr. Irwin Kellner wrote on September 21, it’s another matter whether all the goods being manufactured are sold.  “After declining almost non-stop since the beginning of last year”, he pointed out, “the ratio of inventories to sales has risen in the last two months, reflecting the biggest two-month increase in stockpiles in five years”.   How much longer companies will continue adding to their inventories-and thus, to our nation’s output going forward-is debatable, Kellner added, due to weak job creation and correspondingly weak retail sales growth of late.

            Signs continue to grow that consumers’ ability and willingness to borrow and spend are weakening further.  Though the month of September-according the Fed-was when the economy was accelerating more noticeably, you couldn’t tell that from consumers’ attitudes.   Expected to show a rebound, the University of Michigan’s consumer sentiment index instead fell in September; to 94.2, from August’s reading of 95.9.  Living in the real world distant from Alan Greenspan’s Wonderland, they are paying more than ever for gasoline.  Their heating bills are destined to rise 25% this winter.  Health care and tuition costs are soaring.  They’re in debt up to their eyeballs.  For many, job security is a thing of the past.

            Back to school sales were little better than flat this year compared to 2003.  The tax cuts/rebates have already been spent.  The election and the future itself remain uncomfortably uncertain.  In short-barring a drastic turn of events in too many areas to count right now-consumers are not going to be ratifying the Fed’s picture of the things.        

            As for the subject of inflation, the gap between the numbers that Greenspan points to and those experienced by living, breathing people is becoming a veritable chasm.  According to the F.O.M.C.’s statement following its third 25-basis point hike in short term rates on the 21st, “Despite the rise in energy prices, inflation and inflation expectations have eased in recent months” (Emphasis added).  Sure, the “expectations” of future inflation have eased, as we continue to have a majority of money managers and G.O.P.-leaning economists who would even believe that the moon is made out of green cheese, if the pooh-bahs at the Federal Reserve said it were so.

            The reality-as Yours Truly and occasional guest commentators have often pointed out-is that the government’s official inflation numbers continue to mask “real world” inflation.  Rather than regurgitate all of that, I suggest you visit www.pimco.com, and read the brand new Investment Outlook by the fund company’s Managing Director, Bill Gross.  In his piece entitled “Haute Con Job”, he heaps scorn on the skewed way in which the government uses hedonic adjustments to keep their published inflation numbers down.  His conclusion: consumers and the economy are in more trouble than is generally acknowledged, inflation numbers are grossly (pardon the pun) understated, and those loaning Uncle Sam their money for 10 years at around 4% interest might therefore want to think twice.

            This is the world of reality; a reality that the Fed must ultimately deal with.  As I wrote last month in “Understanding The Game”, its task in the end is an impossible one, given the very nature of the fractional reserve system that the Fed is the custodian of.   Thus, Chairman Greenspan and his comrades at the central bank are reduced to giving us a view of things through their rose-colored glasses, and hoping that ours are of a similar tint.

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