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July 22, 2004

The Maestro Speaks
by Brady Willett

If the Fed fails to acquire a lot more ammo before the US economy reaches recession and/or before an unexpected financial crisis arises, the Fed will have failed...

During his testimony Alan Greenspan said that the slow down in consumer spending will be 'short-lived', that 'attractive' mortgage rates "are providing solid support to home sales", and that "the probability that economic activity might stagnate has receded". Surprisingly, on this last note Greenspan suggested that stock prices - which Alan knows can be influenced by investor irrationality - are one of the indicators that he is paying attention to.

"Both equity prices and capital goods spending have turned up over the past year, and the probability that economic activity might stagnate has receded."

Why Greenspan elected to point out that equity prices are up over the last year is a little puzzling. Perhaps someone should remind Greenspan that US stock prices have epitomized the word 'stagnate' in 2004?

Regardless, in his testimony Greenspan exuded optimism, and ignored the main issue haunting the Fed.

Carefully Hedging His Words

Amidst the optimism Greenspan managed to offer a sliver of gloom; Alan pointed out that corporate profit margins are likely to decline to more 'normal levels'. In fact, Greenspan went so far as to say that "downward pressure on profit margins may already be in train" - something Intel shareholders and tech investors have rudely been awakened to in this earnings season.

However, the reasons Greenspan gave for declining margins were cleverly selected to spin the situation in the most positive of lights. To be sure, Greenspan noted that profit margins are going to decline because of increased competition, declining productivity, and rising unit/compensation costs, but he conveniently neglected to mention that economic slow down also threatens to negatively impact margins. It goes without saying that the US economy - which has already slowed from its breakneck speed in late 2003 - is leaning towards more moderate growth going forward. That Greenspan didn't mention economic growth at all when discussing margins is suspect.

When it comes to jobs, there is no margin for error

A long section of testimony highlights how Greenspan, again, selectively adds to his optimistic outlook. This time Greenspan is talking about jobs and consumer spending.

"...corporate investment in fixed capital and inventories apparently continues to fall short of cash flow. The protracted nature of this shortfall is unprecedented over the past three decades. Moreover, the proportion of temporary hires relative to total employment continues to rise, underscoring that business caution remains a feature of the economic landscape.

That said, there have been much clearer indications over recent months that conditions in the labor market are improving. Most notably, gains in private nonfarm payroll employment have averaged about 200,000 per month over the past six months, up sharply from the pace of roughly 60,000 per month registered over the fourth quarter of 2003.

The improvement in labor market conditions will doubtless have important follow-on effects for household spending. Expanding employment should provide a lift to personal disposable income, adding to the support stemming from cuts in personal income taxes over the past year. In addition, the low interest rates of recent years have allowed many households to lower the burdens of their financial obligations...Despite the softness of recent retail sales, the combination of higher current and anticipated future income, strengthened balance sheets, and still-low interest rates bodes well for consumer spending."

Greenspan applauds headline increases in payrolls. However, he neglects to mention that the latest 'weaker than expected' employment report (for June) produced the smallest increase in average hourly earnings this year. In fact, while some economists are deeply concerned that average hourly earnings are not keeping pace with inflation, Greenspan is completely carefree.

As for businesses still being cautious on hiring, Greenspan avoids this issue by mentioning that companies have a lot of cash. Apparently cash will be spent on hiring new employees (unless it is used for other purposes? ~ purpose 1, purpose 2). Suffice it to say, Greenspan spent little time elaborating on corporate America's cash reserves. Not even Greenspan can competently argue that the inevitable decline in profit margins will occur without crimping cash flows.

Greenspan's argument that a stronger labor market will 'doubtless have important follow-on effects for household spending' did not prove accurate in June. Rather, price increases, 'by eroding households' disposable income, have accounted for at least some of the observed softness in consumer spending of late'. July's payroll report is due to be released on August 6. Greenspan has his fingers crossed.

And while it is true that consumer balance sheets have modestly improved, Greenspan's suggestion that this bodes well for consumer spending going forward is proof that he would make a terrible alcoholics anonymous counselor. Indeed, it is as if Mr. Greenspan believes that a few months of sobriety should be celebrated by going on a binge; in this case a spending binge that consumers can ill afford when taking a historical perspective.

In short, the body of evidence Greenspan produces to drive home his strong consumer spending scenario is skimpy. US consumers have found the means to sustain their spending ways before, during, and after economic recession because of rising stock prices, declining interest rates, the housing/refi bubble, and tax breaks. Betting on wage gains arriving just as monetary and fiscal stimulus efforts ebb is simply that: a bet.

Inflation and The Dollar

Surprisingly, Greenspan offered an honest, albeit brief, take on inflation. To summarize, the Fed doesn't have a clue.

"But we cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation. Accordingly, in assessing the appropriateness of the stance of policy, the Federal Reserve will pay close attention to incoming data, especially on costs and prices."

Not surprisingly, Greenspan skirted around the dollar issue - instead opting to quickly mention how a weaker dollar has impacted prices.

"Core inflation, of course, has been elevated by the indirect effects of higher energy prices on business costs and by increases in non-oil import prices that reflect past dollar depreciation and the surge in global prices for primary commodities."

Given that the overpriced US dollar is one of the most important economic/inflation indicators going, why did Greenspan only mention the word 'dollar' once during his testimony? Because Greenspan aims to produce cheer, not fear.

Nevertheless, while prodded during the Q&A session following his testimony, Greenspan's warned - as he has done before during Q&A sessions (but rarely during his prepared remarks) - that the US's dependency on foreign capital will one day reach a breaking point.

"...at some point we are going to reach a status where our net debt to foreigners, currently now about a little under a fourth of GDP, will get exceptionally large."

Fed Looks To Acquire Ammo

An alcoholic faced with a depleted liquor cabinet will tell you anything if it may help him get a bottle. During his testimony earlier this week The Maestro told us that "Despite the softness of recent retail sales, anticipated future income bodes well for consumer spending." Think about this quote for a moment - (which is made up of three snippets from the sentence noted earlier) --- do you get visions of sugar plums? Or do you get the image of Greenspan telling investors what they want to hear?

With the US economy still expanding and jobs being created, it may seem of little importance that this is the first time during Greenspan's tenure that he is ill prepared to aggressively respond to any unforeseen economic/financial crisis. However, economic growth has recently shown signs of softening, the mad rush into stocks is, apparently, finished, and the Fed has only raised interest rates once. Wall Street expects more tough love from the Fed, but it is clear that The Street is not saying 'thank you Alan, may we have another?'

"Wall Street economists have essentially translated the statement to mean that the Fed will continue raising rates this year by 25 basis points at three of the next four meetings left this year, putting the federal funds rate at 2.0 percent by year-end." CBSM

Needless to say, these are dangerous times for those who anticipate, contrary to Greenspan's opinion, that current trends suggest that future incomes are not going to be all that spectacular. Moreover, these are dangerous times for those who believe that the US dollar is headed for another fall, that the pricing environment will remain extremely volatile, and that the Fed - while not necessarily behind the curve - is nonetheless unprepared for the next curve ball thrown their way.

As Greenspan suggested in his 'don't blame me for the bubble' speeches last year, the Fed's job is to respond to dangers after the blow up. But how does the Fed respond to not having ample ammo to deal with the next unexpected crisis when acquiring ammo represents a danger itself? Judging by his testimony, Greenspan is not so sure at the moment. Rather, he is simply prepared to keep hiking interest rates by quarter points until something happens, and hopes that nothing happens soon.

If lurking dangers come to the surface before the Fed acquires some breathing room Greenspan's legacy will come under intense scrutiny, and the question of whether or not reckless Fed interventions perpetuates unsustainable bubbles could be more seriously asked. The jobs report is due out on August 6. Easy Al will be watching.

Brady Willett
FallStreet.com

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