However they spin today's data, it's no Great Depression

Don't look now, but the Bureau of Economic Analysis at the U.S. Department of Commerce has revised their advance estimate upward and now estimate that the real GDP growth in the second quarter of 2008 was an above-average 3.3%.

Commentators who for one reason or another are invested in putting a negative spin on this blatantly positive news will no doubt find some way to explain away the naked fact that the economy is growing strongly.

Whatever mitigating circumstances they offer, there is no way to square this data with the conventional wisdom that the economy was entering the "worst recession since the Great Depression." Just a few months ago, the media was full of quotations to this effect, repeated so often that anyone who said otherwise was liable to be viewed as delirious.

However, we have been critical of the media's recession drumbeat since last November (see for example our posts here, here, and here). There has of course been a crisis in the financial sector, the long-term causes of which we have dealt with in posts such as this one and this one, but today's GDP number shows that the rest of the business world has generally continued to grow, and recent quarterly earnings reports tend to support that view as well.

The most important lesson from this entire episode in our view is the conviction that you should not base your investment strategy upon trying to time the economic cycles. As we have written before, doing so can cause you to try to "recession-proof" your portfolio or make other erroneous portfolio moves based on the shaky predictions of economists and media pundits. We strongly believe that the best core foundation for a long-term investment discipline is the ownership of well-run, growing businesses whose leadership you trust to make the right decisions for the various economic situations that come along.

For later posts dealing with the same topic, see also:

• "It's a panic, not a Great Depression" 01/21/2009.

• "Managing Investments in the New Era" 02/18/2009.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

Continue Reading

The Fed drops the mask

Back in early March, we noted a troubling quotation indicating that the Chairman of the Federal Reserve, and possibly many other members of the board, believed that slower growth reduces inflation and faster growth increases it.

We noted that this discredited notion held sway through the inflationary 1960s and 1970s until Paul Volcker put into practice the theory advanced by Milton Friedman -- that inflation is strictly a monetary phenomenon and will not melt away by itself when economic growth slows unless monetary policy is also corrected -- and ended stagflation. The very existence of stagflation argues that slowing economic growth does not automatically contain inflation.

After the June Fed meeting, when the Fed's statement indicated that "The Committee expects inflation to moderate this year and next year," we wrote a post entitled "A Phillips-curve Fed?" The Phillips curve was the 1950s-era concept that lower employment would lead to lower inflation, and higher employment would lead to higher inflation. It was hard to believe that anyone still believed in that concept, which had caused so much inflation in the decades before 1980.

Now, however, we are forced to conclude that the Fed is, as Steve Forbes argued in June, "still in thrall to the Phillips curve." On Friday, August 22nd, Ben Bernanke gave a speech to the Federal Reserve Bank of Kansas City's Annual Symposium in Jackson Hole, Wyoming.

Coming during a week in which the inflation data was worse than at any time since 1982, Mr. Bernanke stated that moderating commodity prices and "a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate this year and next year."

This is sheer Phillips-curve thinking. It is difficult to doubt any further that the Federal Reserve is indeed under the belief that slower economic growth will of itself cause the current inflationary pressures to subside.

Instead, as we have argued previously, stable monetary policy will create the environment for business growth, while inflationary policy (such as the Fed has been pursuing for at least a year) will hinder it. By subscribing to the outdated Phillips curve, the Fed can cause the very "weakening outlook and downside risks to growth" that they think will contain inflation.

It is true that commodity prices have dropped sharply, but this is probably due to the unwinding of the speculation that was riding on the back of the actual inflation dragon. That underlying inflation is still there, and our belief that it is a monetary phenomenon means that only monetary policy can tame it.

All of this points to the fact that an investment philosophy which relies on timing the Fed, or playing the resulting moves in commodities, should not be the core of a long-term plan for building wealth. We believe that ownership of innovative, growing, smaller companies in a portfolio help weather the inevitable inflationary flare-ups. Even in troubled or inflationary times, unless you think the economy is going to shut down completely, it will often be the smaller, more nimble companies with a product or service providing new value that will be the engine of growth.

For later blog posts dealing with this same subject, see also:

• "Stand still, little lambs, to be shorn!" 06/03/2009.

• "Milton Friedman, 1912 - 2006" 07/31/2009.

• "The 97-pound weakling" 12/16/2009.

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

• "Avatar and long-term inflation" 03/02/2010.

• "Still in thrall to the Phillips curve?" 03/15/2010.

• "Inflation is a monetary phenomenon" 03/07/2011.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

Continue Reading

The long shadow of the Y2K bug

Remember the concerns during the years before the end of the twentieth century about the "Y2K bug" that threatened to cause airplanes to drop from the sky, nuclear plants to melt down, and electronic data systems and power grids around the world to fail, leading to riots, confusion, and chaos?

It seems almost laughable now, but if you were a bank employee or a member of the Federal Reserve (which has oversight of banks), your recollection of Y2K would be that getting ready for it was no joke. The Fed took the threat of y2K problems very seriously, and conducted extensive preparation for the event in the months and even the years leading up to January 1, 2000.

You might think that Y2K came and went with no ill effects, but you would be wrong. That's because, as we have written before, the effects of Fed oversteering on the economy are enormous.

Look closely at the graph above, which shows the Federal funds target rate in red, superimposed on a graph of the NASDAQ Composite Index in blue, from the middle of 1995 to the present. During the year 1999, the Fed lowered rates dramatically.

To a casual observer, the rate cuts of 1999 may not look that dramatic -- especially in light of the truly historic rate cuts that follow later in the chart -- but if you understand that even a small move of 0.25% in the Fed funds target rate is a major event on Wall Street and the broad economy, with a huge impact on lending and investment and business activities, you will realize that the successive rate cuts of 1999 were actually very significant -- especially because they came at a time when the economy was already on fire and dot-com mania was blazing.

The significance of this excessive money creation is graphically shown by the reaction of the NASDAQ Composite Index on the same graph. Dramatic Fed easing typically results in "malinvestment," or the misallocation of capital due to an artificially altered perception of risk. When money is made too cheap and too plentiful, excesses occur which are commonly called "bubbles." In 1999, as everyone knows, that bubble was in speculative companies found mainly in the NASDAQ Composite. The Fed's 1999 rate cuts poured gasoline on the fire, ending in the NASDAQ flaring to 5048.62 on March 10, 2000.

We believe that this should never have happened -- it was the Fed's ill-timed panic over Y2K and attempt to flush the system with extra cash in advance of it (see for example this article or this article from May and June 1999, with the Fed banks "stocking the vaults" with seven to eight times normal cash amounts, and saying they "stand ready to lend" as necessary) which resulted in a rush of speculative buying in what was hot at the time (telecom and tech-related companies).

Alarmed by the dramatic bubble that they created, the Fed rapidly and excessively tightened rates, resulting in an even more dramatic collapse of the bubble. Unfortunately, the tightening (far beyond the level rates had been before the cuts) came at a time that the economy was beginning to slow, resulting in the biggest deflation since the 1930s, decimating the overleveraged telecom and overextended tech sectors (exacerbated by the previous excessive loosening).

As we have said before, it is this volatile monetary policy which has created the extreme boom-and-bust cycles that have continued since 2000 and resulted in what many are calling a "lost decade" for stocks (major indexes in 2008 are roughly where they were in 1998).

Since then, the Fed has continued this pattern of dramatically oversteering, leading to the housing and mortgage bubbles, which also clearly took off after a period of dramatic Fed easing just as the NASDAQ bubble did, this time beginning with the thirteen-month period when the Fed held their target rate at 1%, seen at the lowest portion of the red line in the graphs above.

The housing and mortgage collapse is still reverberating through the financial sector. In response to its ill effects, the Fed has rushed to the "rescue" just as they did after the NASDAQ bubble, with the most recent series of rate cuts (seen at the right end of the red graph).

This latest overreaction is responsible for the commodities bubble and high gasoline prices of 2008, as well as the inflation that is becoming harder and harder for "inflation doves" to deny. The speculation occurs in whatever asset is hot at the moment -- from 2003-2006 it was real estate and mortgage securities; today it is in commodities.

The Fed's excessively volatile monetary policy destroys the stability that is most conducive to business growth and economic progress. The technological advances that began prior to the NASDAQ bubble and which characterized the growth of the late 1990s are continuing today, but not with the same kinds of benefits and progress we might have seen by now if the Fed had provided an environment of stability instead of the chaos created by their oversteering.

This is the real legacy of the all-but-forgotten "Y2K bug" fever of 1999, and a pattern that we hope future Fed Chairmen will realize and reject.

For later posts on the same topic, see also:

• "Revisiting the 'New Economy'" 05/06/2009.

• "Stand still, little lambs, to be shorn!" 06/03/2009.

• "The Fed's oversteering and the wreckage of the past decade" 07/23/2009.

• "The Bandwidth Revolution" 07/29/2009.

• "What Rube Goldberg could teach us about economics" 12/08/2009.

• "The 97-pound weakling" 12/16/2009.

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

• "Was the decade lost?" 01/14/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Great minds think alike!" 03/19/2010.

• "Why do we want the Fed to steer the economy?" 09/01/2010.

• "Likelihood of Fed over-steering increases" 01/25/2011.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

Continue Reading

"Win and keep your uniforms clean . . ."

Today, the producer price index (PPI) came in up 1.2% for the month of July, twice the increase expected by economists in general.

At the same time, economist Brian Wesbury this morning has an excellent piece in the Wall Street Journal entitled "Inflation is a clear and present danger."

In it, Mr. Wesbury decisively explains why those who argue that inflation is not a threat (for example, because commodity prices have recently dropped, or because "core" CPI is significantly lower than the headline number) are wrong.

"Much like the 1970s," he notes, "there is a widespread denial that inflation is a problem today."

Most importantly, as we have asserted in previous posts, Mr. Wesbury demonstrates that the Fed's attempts to "steer the economy" in addition to its other mandate of providing a stable currency is at the root of the problem.

He uses one of the best metaphors we've heard to explain this problem:

"The Fed's 'dual mandate' -- to keep the economy strong and prices stable -- serves to support this mistake. In contrast, the European Central Bank has a single mandate: price stability. No wonder the dollar has been so weak relative to the euro. Imagine two football teams. One with a single mandate: win. The other with a dual mandate: win and keep your uniforms clean. It's clear that the one with the single mandate will have more success in achieving its goals over time."


For later blog posts dealing with this same subject, see also:

• "The Fed's oversteering and the wreckage of the past decade" 07/23/2009.

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

• "Why do we want the Fed to steer the economy?" 09/01/2010.

• "Likelihood of Fed over-steering increases" 01/25/2011.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

Continue Reading

The Fed is NOT in a "tight spot"

Here is a graph of the Consumer Price Index, from economic and business database specialists Haver Analytics. The graph shows better than words the stark reality that the Fed's excessive easing has introduced unacceptable inflationary pressures into the economy.

According to the July data released by the U.S. Bureau of Labor Statistics yesterday, the CPI is now up 5.6% over the past year. At that rate of inflation, your money will lose half of its purchasing power every thirteen years. If you have a million dollars today, it would have the purchasing power of just $500,000 by the year 2021. If you have a five-year old child now, your dollars when he enters college at eighteen will purchase half of what they will purchase today (at least in terms of room and board: college tuitions have been rising at more than the CPI for several years now).

Many media observers are spinning yesterday's inflation readings as putting the Fed in a "tight spot," because they know that the Fed is supposed to provide price stability, but believe that the Fed cannot afford to raise rates because it would "hurt the economy."

For example, the New York Times yesterday ran a story saying, "The Federal Reserve can try to choke off inflation by raising its benchmark interest rate. But such a move would also make it harder for businesses, banks and households to obtain loans, which could cause a further slowdown in the economy. Investors now expect the Fed to hold rates steady until at least the end of the year."

We strongly disagree. We have argued in previous posts, such as this one and this one, that if the Fed would concentrate on providing a stable currency it would help the economy, not hurt it.

Contrary to the argument from the New York Times quoted above, raising rates and choking off inflation would actually help businesses, banks, and households. As economist Larry Kudlow explained in an insightful blog post a week ago, inflation ripples through the entire economic system, and inflation relief does the same.

Inflation relief can help households on the margin of being able to make their home payments to avoid falling over the edge, which would mean fewer foreclosures, and lower the level of problems inside the collateralized debt instruments held on the balance sheets of various financial institutions.

Businesses would be helped far more by the Fed providing a stable currency than by providing lower rates. Inflation is extremely damaging to businesses that have to purchase more expensive materials or components, and can cause compressed margins as they are forced to either raise prices or eat the difference.

Finally, banks would also benefit from the Fed getting the Fed funds rate back up where it belongs, as we explained in this July post entitled "The dark side of 'making hay while the sun shines.'"

In short, we believe that the people who are calling for more Fed cuts are failing to see the threat posed by inflation, and that those who are saying that the Fed should cut but now will have to hold steady are also misguided. Inflation does not moderate all by itself. We believe that the Fed should raise rates immediately, and agree with Dallas Fed President Richard Fisher who dissented from the majority in the last two Fed meetings, voting for a rate hike in each of them. He also voted in April that the Fed should not have lowered again, although he was outvoted in that meeting as well.

In the meantime, we would argue that the Fed is not in a tight spot at all: they should stop trying to steer the economy, which only creates problems, and stick to providing stability in prices. An inflation reading of 5.6% makes it extremely clear they have work to do.


Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

Continue Reading