Over the last year, the U.S. Federal Open Market Committee has had to deal with two concurrent and conflicting trends when setting its monetary policy. On the one hand, the collapsing housing market has been pushing the U.S. economy to the brink of a cyclical recession. That would normally have meant an easing in the monetary policy of the Fed. On the other hand, the accompanying gains in prices of a broad spectrum of commodities have kept inflation at uncomfortably elevated levels, making the Fed reluctant to cut its benchmark interest rates.
The two trends, if unchecked, would eventually lead to either deflation or to double-digit inflation rates not seen since the 1970s and the early 1980s. Either of the two extremities on their own would cause lasting damage to the economy and to the financial markets. Even at moderately elevated levels, when both are present simultaneously, the impact, known as “stagflation,” would be very troubling.
One of the Fed’s prime mandates is to conduct the monetary policy in a manner that would promote sustainable economic growth, create maximum employment and maintain stable prices. Over the last 50-60 years the Fed has managed largely to optimize its policy to meet these two essentially contradictory objectives. Most of the time, the Fed has not had to take extreme steps to either halt high inflation to the determent of economic growth or accept high inflation to prevent a cyclical recession from deteriorating into a depression.
Among the few exceptions where the Fed single-mindedly targeted one objective, while temporarily sacrificing the other, was in 1980- 1981. Paul Volcker, on becoming the Fed’s Chairman in August1979, drove the federal rate to over 19% by June 1981 to eradicate the double-digit inflation rates that rose as high as 15%. As a result, unemployment soared above 10% in 1982-1983 and the bear 1981-1982 market took a 25% bite from blue-chip indices. It was bitter medicine, but it formed the foundation for one of the longest secular bull runs in the economy and financial markets.
This brings me to the most recent FOMC meeting. After months of inflation being of concern in the FOMC’s statements, this time the very word “inflation” was conspicuously absent in the statement issued.
The Fed, like back in January 2001, cut the federal fund rate by a half a point. The Fed typically reacts to changes in the economy. Not this time. Spooked by the meltdown in credit markets, it acted rather than reacted. Inflation, the sliding U.S. dollar and the rising prices in commodities become temporarily of secondary concern to the FMOC.
Just as in January 2001, following the Fed’s half point cut, the S&P 500 gained as much as four percent from the day prior to the FMOC meeting. Back in 2001, that was as high as the market rebounded following that the initial cut in interest rates from 6.5% to six percent. From then on, successive cuts took the federal fund rate eventually as low as one percent by the time of the last cut of June 2003.
Back then, it came as a rude shock to many market strategists when the market failed to follow the typical pattern of rallying as the Fed cuts interest rates. It was not until October 2002, when the S&P 500 was down 41% from the date of the initial cut, that the market started to revive. I am not expecting an analogous scenario for the post-September-2007 period. Historical patterns, though sometimes very similar, are hardly ever duplicated to the last detail.
It is not a bankable certainty that this time cuts in the Fed’s federal and discount rates will, as they had typically done, provide sustained support to the stock market. Neither is it probable that the shocking 2001-2002 collapse in stocks — when the Fed was frantically reducing its rates to the lowest level in more than 60 years — will be replayed closely over the next two years.
The market rebound from the August 16, 2007, lows has not picked up in trading volume, even after Wall Street traders returned from their summer vacations. A number of negative divergences between price indices, breadth and volume indicators also remain. The same applies to the divergence among important sectors. In general, stocks of companies with either large export business, or having overseas operations are reflecting the benefits of the weakness in the U.S. dollar against all floating currencies.
As a result, the stocks of major U.S. hi-tech stocks lifted the NASDAQ Composite within 3.5% of its 2002-2007 high of July 19, 2007, and, more impressively, lifted the NASDAQ 100 well above its July 19th high. At the other extreme are the lagging sectors, most notably banks, brokers, consumer cyclicals, financial services and home builders. The deepening divergence between the Dow Jones Industrial Average and the Dow Jones Transports is also unsettling. I do not profess to being well-versed on all details of the venerable Dow Theory. However, its principal promise is solid. The Dow Jones Transports average is made up of companies that move goods produced and consumed by the U.S. economy. They are the life-blood of the economy. These days, the Dow Jones Transports index includes the likes of Fedex, USP, and YRC Worldwide, besides venerable railroads. While the DJIA rallied by nine percent from the August 17, 2007, low, the Dow Jones Transports rebounded only by 3.5% and remains more than 11% short of its July 2007 high. The non-confirmation, as they say in technical analysis, of the advance of the Dow Jones Industrial Average by the Dow Jones Transports, accompanied by low volume, give rise to concern about the validity of the markets recent rise.