Discovery Investing: Interest Rates - Too Much, or Not Enough?

Michael Berry
0 Comments|August 7, 2006

Fed needed high enough interest rates to lower if economy slows



Discovery Investing: Interest Rates - Too Much, or Not Enough?

Fed needed high enough interest rates to lower if economy slows

 

By Michael Berry

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Given a softening economy yet stubborn inflation, it now seems that the Fed will pause in its Greenspanian interest rate increase saga. On Friday, interest rates fell across the board in anticipation of this pause. This is not merely a pause but likely to be the end, for some time, of the Fed's interest rate increases. I recently wrote that bonds would reflect inflation. They have not. Perhaps the bond vigilantes are on vacation or simply don't see the inflation in the economy.

The decline of Treasury yields has been startling. Since the beginning of July when the 10-Year Treasury bond yield peaked at 5.20%, and made a three-year high, its yield has fallen precipitously. On Friday it fell again (as did all the other Treasury maturities) to a much lower level, 4.9%.

While Europe, Australia and Britain continue to raise rates to arrest inflation, suck up liquidity and control growth, central bankers in Canada and the U.S. appear to be on the sidelines. The CNBC talking heads are suggesting that perhaps the Greenspan / Bernanke duo went too far in raising rates.

The truth is that the U.S. central bank needed interest rates at a high enough level to lower in the event of an economic slowdown.  While the Fed was raising rates with one very public hand, they continued to flood the market with liquidity with the other hand.

Now that rates have rolled over, Fed policy seems ready to accept a target level of inflation - fearing deflation more than inflation. If this proves out, the U.S. housing market, which is beginning to appear fragile, will be saved.  There are more than $2 trillion in variable mortgage rate resets that will occur in 2006 / 2007.  Mortgage rates have increased significantly. A falling rate scenario may be just what the country's consumer needs.

If interest rates fall and the Fed pauses, the one degree of freedom that will fall out will be the venerable greenback.  Something always has "to give" and it will be the dollar. If so, the price of gold will appreciate as will bond prices, for a while.  If interest rates are held down or decline even stocks might flourish.

In the meantime, there is one very large question for which there is no answer - yet.  Did the Fed raise rates too much or not enough?  In other words, has the Fed pushed the economy over the edge or is there not enough margin to lower rates when growth slows. Japan is the classic case study in this regard.

Has this policy created an interest rate death spiral, lower interest rate lows?  Stay tuned.

 

Michael Berry has been a portfolio manager for both Heartland Advisors and Kemper Scudder, where he successfully managed small and mid-cap value portfolios. He was a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia and has also held the Wheat First Endowed Chair at James Madison University. Dr. Berry is now a proponent of what he calls "discovery investing."

Michael Berry has been a portfolio manager for both Heartland Advisors and Kemper Scudder, where he successfully managed small and mid-cap value portfolios. He was a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia and has also held the Wheat First Endowed Chair at James Madison University. Dr. Berry is now a proponent of what he calls "discovery investing."


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