HARD LANDING NOW WHAT?
Except for the 30-year bond, the entire yield curve is now priced at or below the federal funds target of 6% and the signs of recession are becoming obvious to even the most hard-line bears. A Fed rate cut has become a question of "when" not "if." As we wrote on February 21 ("'Soft' Landing? Don't Count On It"), the Fed's effort to fine-tune GDP growth down to its mythically optimum rate below 3% by doubling the funds target during the course of a year was "unlikely to have a happy ending." Wall Street analysts and the media chatter about whether Friday's report of a loss in May of 100,000 payroll positions signals that a certifiable recession lurks on the horizon. This largely misses the point*, which is that the real economy has been sputtering for months. Real wage growth stopped in last year's fourth quarter and industrial production has registered two consecutive monthly declines. Even if economic activity remains sufficient for a time to skirt a "recession" label as technically defined, this cannot be considered a period of "growth."
Alan Greenspan and the Fed face considerable complexity in the timing and implementation of a move back down the rate ladder. Greenspan knows he has to get interest rates down without increasing the price of gold which for several weeks has steadied at $385 an ounce, down from $395 at the height of the yen/dollar contretemps. This price tells him the economy is not starved for liquidity. Recall that the price of gold was also at $385 when the Fed began "tightening" in early 1994, up from $350 as late as September 1993. The inflation forecast by the dollar's 10% decline against gold in late 1993 was not chased from the system by the Fed's year-long rate-raising exercise, as documented by our "treadmill" analyses. We now observe that the statistical inflation implied by such a move has begun to show up in the conventional price data, as seen below.
The stability of gold during a period of increasing expectations of a Fed rate cut also indicates little current concern about excessive liquidity creation once rates are eased. Greenspan, however, is taking a highly cautious approach toward provision of reserves. The open market desk has been showing a tolerance for funds trading on the firm side of 6% for the past few weeks and has skipped the opportunity to add reserves on several occasions when liquidity injections were expected. To a certain extent, this is part of the Fed's normal "signaling" dance with the money markets letting funds trade weak under current conditions might encourage expectations of a rate reduction before the FOMC is good and ready. In the supply model, a time of slowing production and employment is exactly the wrong moment to "ease." Providing the markets with more liquidity while resource utilization is slackening is a recipe for a classic "too much money chasing too few goods" inflation outbreak. Fortunately, Greenspan probably has a better understanding of this than anyone currently at the Fed. Expansion of the central bank's balance sheet has slowed to a trickle. Ideally, the Fed should allow the funds market to remain tight at the current 6% target until the next FOMC meeting in early July, and even drain some reserves if expectations force the rate to trade at all weak.
Still, from this perspective, with federal funds carrying the same yield as a 10-year note, the bond rally may be nearing its peak for now. The only reason to hold a bond rather than cash, when they have similar yields, is the expectation of a capital gain when short rates decline further. Currently, other short-term market rates are pricing a July funds rate cut of as much as a full point, which is probably ambitious. More likely, the Fed will begin cutting rates the same way it began raising them last year a little at a time. Also, the somewhat higher inflation numbers that we expect to see in the next few months will likely increase the level of caution among bond buyers, although our analysis suggests that a higher price level was fully discounted in last year's market blow-out.
After 28 months of Clinton Administration economic policy, all trust must now be placed in the skills of Alan Greenspan to levitate an economy that is suffering heavy burdens to risk-taking and capital formation. In a real sense, this burden is considerably higher than it was when President Clinton took office. First, the tax increases of 1993 remain the defining event of the economy's declining potential. Second, gold at $385 implies a 10% increase in purely inflated capital gains, which also suffers increased tax liabilities. Operating at his best, Greenspan cannot overcome this heavy burden. He needs tax relief from a Congress that seems headed for gridlock on this issue. This is why the surge in unemployment, taken as "good news" by the bond market, may also turn out to be encouraging to equities. This would be the case if political pressures on the Democratic White House and Republican Congress leads to a deal on capital gains relief.
Last weds we promised you a statement from Steve Forbes announcing his serious consideration of a presidential run. A glitch developed when lawyers who specialize in the federal election laws advised that even a statement of serious intent would constitute a declaration of candidacy. This would trigger myriad compliance rules that apply to campaign finance, in ways that make it much more difficult for a private citizen to run for president than an official who already holds elected office. For practical purposes, this means he would have to have a staff in place independent of the Forbes empire just to announce serious intent, and could not spend more than $5,000 without registering with the Federal Election Commission. He's already swamped with requests for interviews and doesn't have anyone who is even allowed to field the requests. It will take a few weeks to pull together the beginnings of a team and rent office space. The serious intent will be self-evident in the process, but you can count on serious intent. He was a featured speaker Friday at the Mackinac Island conference, the biggest formal political event of the year in Michigan, and wowed the 1000 people in the audience. Gov. John Engler threw a special reception for him. Steve will be interviewed by Judy Woodruff on CNN's Inside Politics, tonight at 8:30 EST.