By William Patalon III
Managing Editor
Money Morning
Where is Paul Volcker when you need him?
The U.S. economy is between the proverbial rock and a hard place. And the U.S. Federal Reserve under chairmen Alan Greenspan and Ben S. Bernanke has played a big part in putting us there. But it's Bernanke's actions that have me the most concerned.
In deciding whether or not to cut interest rates in the face of the subprime-mortgage debacle, some might say that Bernanke faced a Hobson's Choice, though I'm not sure I can agree with that [for you Boston Red Sox, or BoSox, fans out there, the Hobson I'm referring to is a literary reference and has nothing to do with choices made by the legendary Butch Hobson. Just so you know ..].
The rationale for twice cutting the benchmark Federal Funds Rate since mid-September is very clear. With the U.S. economy groaning under the burden of soaring crude oil prices, a housing market that's in a freefall, and a broad credit crisis that's spilled out of the subprime-mortgage mess, Bernanke dug into the dog-eared U.S. Federal Reserve playbook. He slashed rates, hoping that by steeply reducing borrowing costs, the U.S. economy would avoid a recession.
Unfortunately, there are also some real downsides. Especially right now.
As the daily headlines remind us, the U.S. greenback is in big trouble. It's at three-decade lows against such major currencies as the British Pound Sterling, and historic lows against the European euro and the Canadian dollar, to name just a few.
By cutting interest rates - especially at a time when the problems plaguing the U.S. economy make that market about as undesirable as possible to foreign investors - the greenback becomes even less desirable for overseas investors to invest in. That alone means the dollar will continue to fall.
But there are other considerations: Other central banks are holding rates steady, or even raising them, dramatically increasing the relative value of these other currencies versus the dollar.
A falling dollar does have certain advantages. It's great for U.S. exporters, for instance, particularly major ones such as airliner maker Boeing Co. (BA). Unfortunately, in a market like ours that depends so heavily on imports, a falling dollar becomes highly inflationary.
We've all become spoiled by the plunging prices for computers, consumer electronics and other products made abroad. But a dollar that's declining in value against other currencies is essentially the equivalent of a huge, across-the-board price increase on anything imported. And that includes oil, which would be climbing into record territory even without the assistance of the falling dollar.
It's interesting - and ironic - to understand that two key Fed mandates are to maintain economic stability and strength and to keep inflation at bay.
In this case, however, those two mandates are contradictory, and impossible to simultaneously pursue. By cutting interest rates to keep the U.S. economy moving along, the Fed is actually fueling inflation.
And I think it is making the wrong choice.
Back in the 1970s, Fed Chairman Paul A.Volcker looked at an economy that was breaking down under the weight of "stagflation," which included an inflation rate that was climbing and would peak at 13.5% in 1981: He raised short-term interest rates up to record levels, which ultimately pushed the economy into a recession. But Volcker squeezed inflation out of the U.S. economy, and it never returned. Until now.
Greenspan is remembered as the economic genius today, but believe me when I tell you that Volcker was "The Real American Economic Hero."
It truly is a tough choice, opting to intentionally create a recession, with all the job losses and other accompanying pain, at least in the short term. There are long-term benefits to this kind of a strategy - to the strategy embraced by former chairman Volcker.
First and foremast, inflation is the financial markets' version of a cockroach: Once it takes up residence, eradicating it is virtually impossible.
Second, there are cleansing effects that downturns - such as a recession - can have. In the current environment, boosting interest rates would make the dollar more attractive to foreign investors, lifting its value and squelching the inflationary pressures that are becoming apparent. It would also exacerbate the default rate in the subprime-related debt instruments that are already now teetering on the brink.
Why is this good? Many of these defaults are still going to happen; they've merely been delayed by the Fed rate cuts. Better to let those defaults happen now, and let the U.S. economy more quickly work itself back into fighting shape.
That's what Paul Volcker would have done.
After this past week, I have to think that shell-shocked U.S. investors are wondering about many of these same things. For the week, the Dow Jones Industrial Average plummeted by more than 550 points, or about 4%. The Nasdaq Composite Index plunged by more than 6%, while the Standard & Poor's 500 Index dropped by more than 3.5%.
The small-cap Russell 2000 Index now stands in negative territory for the year. More write-downs related to the ongoing subprime mess - combined with some earnings warnings and a few negative predictions by Fed officials ... and the equity freefall was on.
Retailers grew more fearful about their upcoming holiday season as the earlier-than-normal discounting failed to produce the hoped-for early dividends. With everyone and their brothers [and mothers, fathers, in-laws, dogs] shying away from stocks, the winners were investors in fixed income and gold. Oil soared on the ongoing supply concerns [and speculation that it will soon surge passed $100 a barrel, and just keep going.
The Week That Was ...
| Market/Index |
Previous Week |
Current Week |
YTD Change |
|
Dow Jones Industrial |
13,595.10 |
13,042.74 |
4.65% |
|
NASDAQ |
2,810.38 |
2,627.94 |
8.80% |
|
S&P 500 |
1,509.65 |
1,453.70 |
2.50% |
|
Russell 2000 |
797.78 |
772.38 |
-1.94% |
|
Fed Funds |
4.50% |
4.50% |
-75 bps |
|
10 yr Treasury (Yield) |
4.29% |
4.23% |
-48 bps |
A number of top chief executive officers started retirement a lot earlier than they probably expected last week. Welcome to CEO Central, where the subprime shuffle has created a most interesting game of executive musical chairs.
Two weeks ago, the CEO of Merrill Lynch & Co. Inc. (MER), E. Stanley "Stan the Man" O'Neal, was shown the door [rather...offered early retirement] and BlackRock Inc.'s (BLK) Laurence Fink seems the likely successor. A day later, the CEO of Citigroup Inc., (C) Chuck Prince, decided to join O'Neal in the "former CEOs club" [or actually it was decided for him]; Robert Rubin, of Goldman Sachs Group Inc. (GS) and former treasury secretary fame, will become chairman with Sir Win Bischoff acting as interim chief executive. [Does that "Sir" title add some credibility to the troubled bank?] The hiring/firing/retiring bug even moved beyond financial companies as Time Warner Inc. (TWX) announced that CEO Richard Parsons was being replaced after a five-year tenure that saw its stock price remain relatively stagnant [and investors demanding better].
Wachovia Inc. (WB) and Morgan Stanley Inc. (MS) became the latest financial firms to announce significant write-downs on mortgage-related securities. And the damage was not limited to domestic companies. Across the pond, rumors have Barclays PLC (BCS) about to report a $10 billion loss in asset valuation.
While financials have been hammered in recent months [both with negative news and performances], techs had been the one savings grace for the markets. Well, this week, they took a tumble as well. Networking giant Cisco Systems Inc. (CSCO) warned of future disappointments as businesses cut back on IT expenditures. Chipmaker Qualcomm Inc. (QCOM) also speculated that 2008 will be a challenging year as an economic slowdown and legal issues hinder the company's operations. Google Inc. (GOOG) moved forward with aggressive plans to expand into the cell phone industry, though the stock got caught up in all the tech-sector negativity and investors took profits from its seemingly never-ending ascent. Alibaba.com, a Hong Kong-based e-commerce company, launched a highly successful IPO that saw its share price triple on the first day of trading [and left investors like Yahoo Inc. (YHOO) slapping high fives...if you can't compete with Google in R&D, invest in firms that can]. On the earnings front, General Motors Corp. (GM) reported a record $39 billion loss in the third quarter after three straight favorable quarters; rival Ford Motor Co. (F) also posted a loss, though it was not as bad as Wall Street feared.
Oil prices continued their rapid and inexorable climb toward the $100 a barrel mark, as geopolitical turmoil in Afghanistan and Yemen raised more concerns about supply issues. With prices surging more than 40% since August, gasoline is following suit and moved above $3 per gallon on average. The dollar weakened daily, and investors turned to gold [which hit a 28-year high] as a hedge against everything negative these days. Financials led the already-plummeting market lower last week as Citigroup, JPMorgan Chase & Co., (JPM), Bank of America Corp. (BAC), Wachovia, and Well Fargo Co. (WFC) all fell to 52-week lows early in the week. The carnage continued with the Dow tumbling more than 360 points Wednesday and the tech-heavy Nasdaq taking its negative cues from the Cisco and Qualcomm warnings. A few ill-timed comments by Bernanke [see below] did not offer any comfort late in the week as investors again moved to the safe-haven of treasuries; the yield on the 10-year dropped to around 4.25%. With ripples from the subprime debacle and credit crisis-widening daily, are any execs [not named Sir] truly safe these days? Sometimes it's best to remain stuck in middle management.
Economically Speaking...
* Reflects changes in interest rates over various time frames.
Weekly Economic Calendar
| Date |
Release |
Comments |
|
November 5 |
ISM (Services) Index (10/07) |
Stronger than expected growth in services sector |
|
November 7 |
Consumer Credit (09/07) |
Lower level of borrowing in 5 months |
|
November 8 |
Initial Jobless Claims (11/03/07) |
Fewer benefits claims for third consecutive week |
|
November 9 |
Trade Balance (09/07) |
Best showing in 28 months |
|
The Week Ahead |
|
|
|
November 12 |
Veterans Day Celebrated |
|
|
November 13 |
Treasury Budget Statement (09/07) |
|
|
November 14 |
PPI (10/07) |
|
|
|
Retail Sales (10/07) |
|
|
November 15 |
CPI (10/07) |
|
|
|
Initial Jobless Claims (11/10/07) |
|
|
November 16 |
Industrial Production (10/07) |
|
Retailers struggled through a disastrous October and are now more concerned than ever about a holiday shopping season that's careening right at them like a locomotive.
Same store sales were below expectations across virtually all retail sectors as Limited Brands Inc. (LTD), Macy's Inc. (M), Nordstrom Inc. (JWN), and Wal-Mart Stores Inc (WMT) [among others] all reported disappointing results. Unseasonably warm weather hindered demand for winter wardrobes and ongoing economic concerns kept shoppers out of the malls and strip centers. The International Council of Shopping Centers (ICSC) survey depicted the weakest pace of October sales since 1995. Furthermore, another consumer confidence measure fell this week and the September level of consumer borrowing rose by a much smaller than expected percentage. And while the key shopping period for the holidays traditionally does not start until November, analysts still fear the latest results [and reports to come] are a precursor of a painful shopping season.
With a limited calendar, investors turned to Team Bernanke for another assessment of the economy [as if the recent Fed meeting and related Fed-speak did not provide sufficient information]. In his report to the Joint Economic Committee of Congress, Bernanke warned that growth would slow from its robust 3.9% pace in the 3rd quarter as housing woes and energy-related inflationary pressures threaten businesses. He also predicted that the economy was not headed for recession and that the country should begin to experience a rebound by mid-2008. One positive byproduct of the weak dollar showed up this week in the trade statistics, as the deficit fell in September to its lowest level in 28 months. On a year-to-date basis, the deficit remains 7.4% below last year's record. OK Prez W...time to reappear from hibernation and take some credit for a change. And while we're handing out kudos, how about some for Mr. Volcker, too?
News and Related Story Links:
- Baseball Reference.com:
Butch Hobson. - Baseball Reference.com:
The Boston Red Sox. - Wikipedia:
Paul A. Volcker. - Wikipedia:
Stagflation.