Does the current Fed tightening suggest an impending recession coupled with inflation? The combination of spiraling oil prices, a weak dollar, and the Fed's holding interest rates well below the economy's actual growth rate (in negative real rate territory) has many economic forecasters predicting inflation—and even stagflation which is considered the worst of both worlds: inflation without growth. Indeed each one of the above concerns is a precursor for high inflation, but none are perfect predictors and have even flashed false alarms in the past. While the stagflation scare has not reared its ugly head since the 1970's, the world economy is significantly different now and therefore we feel the factors noted above as omens will have a different effect on the economy, and not lead to stagflation.
So what's the Fed up to? Why did Greenspan et al allow negative real rates to continue well after stimulative measures (enacted to limit the recession) seemed to be necessary? We think the Fed kept rates low for an extended period of time to fend off the global deflation that has mired the Japanese economy in an extended period of malaise and pushed the European economy to the brink of recession. Lower rates put pressure on the U.S. dollar which in turn puts pressure on Japan and European economies to rethink their export driven economic models. Despite tough talk, the Fed has not taken actions to meaningfully defend the dollar in global markets, which suggests there is an intent behind such acquiescence: As the weaker dollar cramps foreign business and policy makers' hopes of exporting their way out of a recession, it becomes a trade tool to encourage more growth oriented demand-based economic models in these developed markets.
While we approve of promoting internal-demand based economies, this tactic of combining a negative real interest rate policy with a weak dollar has not been without risks: The tactic has extended the credit cycle and as a result excess credit creation appears to be causing some other structural imbalances. The excess credit produced by the Fed's tactic has contributed to rising asset prices primarily through the low cost of borrowing, as demonstrated in the spectacular rise in U.S. real estate prices and the propagation of hedge funds. The surge in the number and size of hedge funds highlights additional risks. Access to cheap or low cost capital for hedge funds is nearly limitless, and the barriers to entry and regulation are almost non-existent—a recipe for speculation in anyone's book. Hedge funds generally use leverage to increase return potential by borrowing short term and lending long term. For example, they borrow at a slight premium to LIBOR to purchase stocks, bonds, and other assets. This asset liability mismatch can become unsustainable and, as we have seen in the past, cause great damage to the economy as past banking industry asset/liability mismatches have done. The mortgage lending market has also changed in the past few years as more borrowers are opting for floating rate mortgages despite the near historical low rates for fixed-rate mortgages, thus adding to the problem. We think the Fed's recent concerns about the degree of leverage introduced into the housing market by Fannie Mae and Freddy Mac indicate the risk they see currently embedded in the financial markets.
As a result of these concerns, the Fed has been increasing short term rates because of the need to de-lever the bond market, the housing market and hedge funds. The inflation risk, while rising slightly, appears to be a distant secondary risk. The bigger risk for the global economy now is a financial market implosion resulting from excess credit leverage, which could lead to a global recession. Thus, rather than the economy going into a recession and taking the financial markets with it, it is the financial markets themselves that have the potential to cause a recession. We view the Fed's current rate hikes as a tactic designed to wring the most levered risk out of the markets and to penalize excess speculation. Indeed, in recent months we have seen the effect of such squeezing on overly levered products and the implosion of many hedge funds, hopefully leading to more normal levels of leverage in the marketplace.
Inflation occurs when the demand for goods exceeds the supply of goods. Today we have a surplus of goods without enough demand—a very different phenomenon. The stagflation scare is not a likely concern in a world with excess capacity and a lack of demand. But, as we do face the concern of excess credit that is manifested in asset prices and financial markets, especially in the bond market, the Fed is responding as it did in 1994 when rate hikes squeezed the bond market and hedge funds. In 1994, much like today, inflation was not a major risk while economic growth was not in a runaway mode either. Also like today, leveraged credit posed a greater risk than inflation. Given these similarities, we believe the Fed's current actions and the market environment are more like 1994 than the stagflation of 1974. (The table below shows some of the similarities between the situation in 1994 and today, and also notes the strength of the markets in the period after the rate rises had apparently started to take effect.) Right now, the Fed is raising rates to reduce excess credit and induce more growthoriented policies abroad. If managed correctly, the global structural imbalance in excess credit and the developed markets' unfunded liabilities can be resolved with a healthy dose of global growth-driven policies that encourage domestic consumption in Europe and Japan while providing incentives for U.S. investment.
