“Pennies don’t fall from heaven; they have to be earned on earth.”
- Margaret Thatcher

Skipping a Beat?
With the Fed having raised rates for the sixteenth straight time, to 5.00% this week, markets are increasingly focused on signs that the Fed may take a breather at its next meeting, scheduled for June 28 – 29. Indeed, on April 27, Chairman Bernanke told Congress that the Fed could halt the streak even in the midst of escalating inflation signs. Nonetheless, just a few days later, the financial markets were vexed by reports that Mr. Bernanke told CNBC that the financial markets were wrong to think that the Fed’s move toward higher rates is complete. This is not the first time that a nascent Fed chairman has had trouble with the press. At his first and only television interview in 1987, Alan Greenspan unraveled the bond markets by commenting on the role of consumer psychology upon inflation.

In any event, futures markets are now assigning approximately a 75% chance that the Fed will wait to raise rates again at least until the August meeting in order to step back and assess the effect of two years of consecutive rate increases upon the economy. The Fed appears to want to balance current economic data with the past lessons of history, namely over-aggressive tightening seeding the grounds for a recession.

A Vacillating View of the Economy
Short-term rates have increased consistently over the past two years, but it’s only been over the past three months that long-term rates have begun to rise in tandem. Indeed, for the first four months of the year, the yield on the 10-year Treasury increased by more than 70 basis points. An investor would have sustained a negative total rate of return of 4.25% over this time frame—the worst performance in over a decade. Is the economy weakening with the Fed in the eighth inning of its tightening campaign? Alternatively, is the economy above the speed limit and still in need of tighter monetary policy?

Let’s observe the economic crosswinds.

There are some data that indicate that the economy may have cause for a pause:

• Energy prices: In spite of the fact that oil consumption as a percentage of GDP has been halved since the crises of the 1970s, few doubt that rising energy prices will have the same dampening effect upon the economy as a consumption tax.
• Housing: There are indications that this sector is slowing down. As an example, the National Association of Realtors reported that the sale of previously owned homes dropped to a two-year low in March. With a decline of 7.8% for the month of March, new housing starts descended to a one-year low. The recent rise in fixed-rate mortgages may have started to chip away at home buying and mortgage refinancing activity. Home equity has been a large source of consumer spending growth. According to the FDIC, during 2005, the amount of home equity that was extracted in the form of cash out refi’s, increased mortgage balances, and outright cash-out sales was estimated to be between $444 billion and $600 billion. Either figure dwarfs the 2005 estimate of a $375-billion gain in after-tax income. Indeed, in his April 27 testimony, Chairman Bernanke stated that housing and its role in generating wealth creation, relative to income gains, “could be a drag on growth this year and next.”
• Consumer debt: After reaching record levels, consumer installment debt appears to be slowing down. During March, consumer borrowing increased at a rate of only 1.4%, down from a 2.5% rate of increase during February. Revolving consumer credit card debt declined by 0.2% for the month.
• Tepid job creation, geopolitical uncertainty, projected slowing in GDP growth: Defying a projection of an increase in April non-farm payrolls of on the order of 200,000 workers, the actual number came in at 138,000. Russia and China appear to be balking at the next step of enforcing the U.N. Security Council’s request to cease production of enriched uranium. Beyond Iran, resource nationalism is creating additional geopolitical uncertainty—the most recent examples being Bolivia’s nationalization of oil and gas supplies and Russia’s refusal to expand access to its state-controlled gas pipeline to countries within the European Union. Not an illogical assumption, then, that second-quarter GDP growth will not come in at much more than 3%—a far cry from the 4.8% rate of growth that occurred during the first quarter.

To make matters all the more confusing, economic tailwinds appear to be blowing at an even higher velocity.

• Behind the scenes – a healthy job picture: The unemployment rate remains at 4.7%, the lowest rate in over four years. During April, the workweek increased to 33.9 hours, from 33.8 hours. Overtime also increased. There was also a reversal in labor productivity, which declined by 0.5% during Q4 2005. We saw a healthy increase in the Q1 productivity rate, at 3.2%.
• Percolating inflation: For the Fed to seal a June pause, inflation numbers for April and May will have to be muted. The March Consumer Price Index increased by 0.4%, and core prices rose by 0.3%. Thanks to global demand, we’re not getting much help on the commodity price front. While the rising price of oil grabs the headlines, copper prices have doubled over the past 12 months, and gold is at a 25-year high. Furthermore, there is evidence that price increases are now being passed through to the finished goods level. Has anyone grabbed a bargain airfare lately? Count on having an empty seat next to you this summer?!
• Inflation indicators: Color them “yellow,” as in caution. Treasury Inflation Protected Securities (TIPS) trading activity is indicating market expectations of an annualized consumer inflation rate of 2.67%. That’s an increase from the year-end implied expectation level of 2.34%. Thus far in 2006, the rate of core consumer inflation is 2.8%, an increase from the 2005 level of 2.2%. The Fed’s preferred measure of inflation, the personal consumer expenditures deflator, came in at an annualized rate of 2.0% for the month of March–at the top of the Fed’s stated band of tolerance. We’ll see how much longer the greatest sources of inflation containment—global outsourcing of manufacturing and labor and technology—can hold off the price pressures that are boiling over on the raw materials side. Don’t forget that the inherent value of a copper penny is now 1.25 cents!
• Corporations are flush with cash and the capital spending cycle is gaining momentum. Companies that became leveraged in the earlier part of the economic cycle, as did homeowners, have been able to refinance and obtain lower interest rates and extended maturities. The corporate earnings season has never been better in terms of the percentage of reporting companies outpacing street estimates.
• Consumers remain confident. The Conference Board’s confidence index for the month of April rose to its highest level in four years. Why the confidence in the wake of rising energy prices? The jobless rate remains low and household balance sheets have been bolstered by strong equity markets and successive years of housing appreciation.

Intuitively, economic crosswinds portend increased volatility or variation of returns in the fixed income markets. As we’ve stated in the past two issues, interest-rate cap volatility is at its cyclical low. Interest rate options and capped, floating-rate advances may warrant further consideration.

Top of the Food Chain: The Current Account
If you were in Chairman Bernanke’s shoes, would you avoid the risk of further dampening a cooling housing market and creating the degree of dislocation that we saw in 1995 with the erasure of economic growth and an international currency crisis? Alternatively, would you further tighten the monetary screws with the realization that inflation indicators are flashing? These are good questions, but the impact of the Fed’s good intentions may ultimately be superseded by global currency developments.

While the markets spend most waking hours pondering the prospects of the Fed catching its breath, a sleeping 800-pound gorilla, the mounting current account deficit, is letting its presence be known in the form of a weakening dollar. In addition to the anticipated pause in Fed rate increases, the dollar has weakened, of late, primarily due to speculation that the U.S. Treasury views a weaker dollar as a key antidote to a yawning current account deficit, now at seven percent of GDP. It doesn’t help that the G7 recently urged countries with trade surpluses to increase currency trading volumes (read: chip away at trade imbalances via the currency markets, a.k.a. sell the U.S. dollar).

The likely net effect of an awakening 800-pound gorilla and an associated decline in the U.S. dollar? Higher long-term rates, as central banks and international pension funds demand an additional risk premium. Some way to return to a normal yield curve!

John Biestman is director of business development at the Federal Home Loan Bank of Seattle.

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