Wednesday, June 06, 2007


I've thought for a while that the Fed would, characteristically, overshoot on the way up (raising rates). It does look like that will happen, although possibly not for reasons that one might expect.

Consider that central banks around the globe are raising interest rates and generally slowing the growth of liquidity. (I don't know if you could say they are stopping or reversing it, but attempting [halfheartedly?] to slow it.) So now, based on the (flawed?) economic feedback that the Fed seems to be getting for the second quarter, it looks like they may be forced to raise the Fed Funds rate by at least 25 basis points. (Most likely 25, since when was the last time this Fed was aggressive?)

Its clear that there is weakness in the economy already. (I wish there was more in residential RE in the Washington, DC area, but that's a topic for another time.) So however the Fed is monitoring the state of the economy would appear to be broken. However, using their flawed data, and comparing this with the relatively low rates on the books in this country, as well as the effects of rate raising by other CBs, and I can see a scenario where the Fed is forced to overshoot. Should this happen, it will only induce more pain on consumers, leading to slower economic growth and a more potent slowdown than many commentators seem to be expecting already. Its not like the Fed will raise rates to stop the dollar's decline (at least, not purposefully). They don't care if the dollar is competitive against other currencies; this administration seems to be quite strongly in favor of a weaker dollar. BUT the politics factor will come into play, and voters don't like politicians who preside over high inflation. (At least, they shouldn't BUT...) In that case, you could be looking at bad bond returns through the end of the year (especially Treasuries) without a chance for easing until early 2008. Did I miss anything?

Stephanie Pomboy said it a while ago in the pages of Barron's, and I'm going to agree now -- if you don't see at least the case for stagflation, you're crazy!

Now, will it be a full on 70s style stagflation? I don't friggin' know! I doubt it, actually, but I do think stagflation is the right word. (Personal opinion.) But I think the answers are pretty clear in terms of what to invest in going forward.

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