Jewish World Review March 28, 2000/ 21 Adar II, 5760
http://www.jewishworldreview.com -- ON THE EVE of the Fed's interest rate policy decision, the single most important piece of information is the big Treasury bond rally that has taken place over the past two months. Thirty-year Treasuries have eased to 6% from 6.75%. The 10-year price has improved to 6.18% from 6.80%.
Call it the silent bond rally. No one seems to want to talk about it. But it represents big news: long-term inflation expectations are declining. The drop in long-term rates is more important than the temporary oil shock or other readings from various inflation indexes. The message of market prices is more significant than government statistical releases. It's a non-inflationary message.
Far too many market participants cling to the notion that Treasury buy-backs are responsible for the drop in long-term rates. But this is overstatement. The Treasury isn't buying back 10-year issues. However, since the last FOMC meeting on February 2, the 10-year has outperformed the 30-year by 11 basis points.
Behind the decline of inflation expectations is a major cash draining operation conducted by the Fed. Since year-end they have wiped out $84 billion from their balance sheet, taking Reserve Bank credit to $561 billion from $645 billion. As a result, the growth of Fed credit has slowed to 10% from 25% on a year-to-year basis. Look for more slowing ahead.
Also as a result of the Fed's reserve drain, "excess money" (year-to-year change in the monetary base minus MZM) has fallen to 2% from 8%. In other words, high-powered money supplied by the central bank is in much better balance with money demanded by the economy.
So, along with the bond rally, gold and commodity prices have eased. Less money deflates interest rates and real asset prices. On the raw material front, outside of oil, the CRB spot index has fallen 5% since November, the Journal of Commerce spot metals index about the same and the Goldman Sachs non-energy index has lost 3%. Call it price stability.
Gold is off 12% from October and 9 1/2% from its recent high in early February. The dollar index has appreciated 8 1/2% since last October, and 5% since the turn of the year. The TIPS to 10-year spread has come in 30 basis points since mid-February and is now about 200 basis points. The entire coupon portion of the Treasury yield curve is inverted, with 30-years about 51 basis points below 2-years. More price stability.
Money supply indicators of transaction demands are registering significant slowdowns. Yearly M2 growth has slowed to about 5 1/2% from nearly 9% at the end of 1998. On a higher frequency basis, the three-month growth of M2 has fallen to 5% from 12%. Trend MZM growth has downshifted to 8% from over 14%. Over the past two months MZM growth has dropped to 2.9% at an annual rate.
Have Fed actions slowed the economy? Most analysts say no. But monetary trends are signaling yes. It's fashionable to ignore money; Alan Greenspan doesn't even mention it anymore.
But money matters. Not just the excess of money supply over demand (which is shrinking, hence gold and long-term interest rates are falling, oil will too before long, and the dollar index has appreciated). But also money demand is slowing (MZM and M2 growth) -- in part because the Fed has raised the funds rate 100 basis points. The slowing in transactions demand growth is a coincident to leading indicator of consumer spending.
There's a wee bit of a credit crunch developing. First, total bank credit growth has slowed to 5% from 10%. Second, the spread between Baa-rated corporate bonds relative to long-term Treasuries has widened 70 basis points this year. Third, the Fed is jawboning banks to tighten their lending standards.
The interest-sensitive housing sector is showing the first signs of economic slippage. Here's some of the wear and tear:
* Overall housing starts on a year-to-year basis are rising at 3% compared to twin peaks of nearly 20% last year. Single family starts are declining at a 5% rate.
* The homebuilders index has slumped to a 10% decline rate from a 40% increase.
* New home sales are falling at a 4% rate. Early last year they were rising at a 20% pace. Median prices for new home sales have eased down to 1.2% for the latest twelve months, after running around 8% for most of the last two years.
* Existing home sales are declining at a 10% rate, after rising at nearly 20% for much of 1998 and 10% for most of 1999. Median prices for existing home sales have fallen back to 1 1/2% over the past year, after peaking at 7% in 1997, 6% in 1998 and 4% to 5% in 1999.
* I know, I know, Upper East Side Manhattan numbers are interplanetary. Ditto for Fairfield County, the North Shore of Chicago, Silicon Valley and so forth and so on. But what about East St. Louis? Downtown Newark? Butte, Montana?
Here's another point about the economy, especially consumer spending, which will still be strong in the first quarter. Just as soon as Alan Greenspan started attacking stock market wealth and consumer spending last year, then backed it up with a bunch of rate hikes, folks got moving and spent their keisters off before rates got even higher. This happens all the time. But keep in mind, this accelerated spending may well be borrowed from the future. Hence future sales are likely to slow.
So let's pull this together. Here's what we know: inflation expectations are declining, liquidity is scarce and economic demands appear to be slipping. Both inflation-sensitive market price indicators as well as a spate of money and housing data are telling the Fed to go slow.
Another reserve drain will insure that the OPEC price hike will not be
monetized. Okay. Beyond that, however, the Fed should keep its powder dry.
If it ain't broke, don't fix
JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.
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