Navigating the Economy Between the Rocks of Recession and Inflation

It has been almost one year since the Fed, during its June 29, 2006 FMOC meeting, increased its benchmark interest rate to the current 5.25%. The continued neutral monetary policy followed by the Fed over the last 12 months lends itself to two very different interpretations as far as the economy and the financial markets are concerned.

The positive scenario, one that equity investors have wholeheartedly embraced over the last year, involved an economy that is neither too hot nor too cold, but just right. This dominant Goldilocks sentiment has helped the leading U.S. averages to gain more than 20% over the last 12 months.

The bearish scenario would have the economy sliding into a cyclical recession while rising commodity prices and a declining U.S. dollar elevate inflation well above the Fed’s target range of one percent to two percent. In the bad old days of the 1970s, an extreme version of such a combination of events had even its own term — stagflation. This scenario is the dilemma the Fed has to deal with. Its persistence has been subtly acknowledged in several recent statements from the FMOC, including the following excerpts from the May 9/07 meeting:

“Economic growth slowed in the first part of this year and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to expand at a moderate pace over the coming quarters.

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“Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

“In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth.”

My guess on what direction the Fed’s eventually shift the federal interest rate is no better than the multitude of projections and advice offered by leading economists and other kibitzers of the Fed’s policy. Since the May 9th meeting the Fed’s dilemma has not gotten any clearer or brighter.

The steadily deflating housing bubble is taking an increasing toll on consumers who got in over their heads with adjustable mortgages on houses acquired through the irresponsible lending practices of the financial industry. Dozens of subprime mortgage companies have already filed for bankruptcy protection, and as many as 3 million American homes may face foreclosures during 2007. Losing their homes and facing rising food and fuel prices, the U.S. consumer can no longer be counted on to keep the economy humming.

The housing woes are already being discounted by the underperformance of stocks of companies relying on consumer spending and companies that financed the housing bubble. The SPDR of consumer discretionary spending, still below its February 2007 highs, is held down by the weakness in the likes of Wal-Mart and Home Depot.

ETFs invested in banks and other financials are also below their February 2007 highs. The weakest stocks are those of Wall Street dealers that have exposure to subprime mortgages; namely Bear, Stearns & Company Incorporated; and HSBC Holdings. For several years they profited hugely from the financial alchemy of taking low-grade subprime mortgages and repackaging them into investment grade securities sold to yield-hungry foreign and domestic institutions. Now, with some of the so-called “Collateralized Debt Obligations” down 20%-30% below their face values, multibillion-dollar litigations are very likely.

While the problems of the housing market have been getting extensive press, little attention has been paid to the weakness in commercial real estate. The REIT for iShares (IYR) topped out on February 8, 2007 at $95.00. Since then IYR completed a head-and- shoulder top and last week closed 14.5% below its February high. This may just be a coincidence, but in February 2007 the legendary real estate investor Sam Zell sold his REIT Equity Office to Blackstone Group for $23 billion.

The impact of a deflating housing market, which accounts for 23% of the U.S. economy, could be alleviated by aggressive cuts to the federal fund rate, if only not for the pesky inflation rate. The latest annual increases of 2.6% in the All Items CPI and 2.3% in the Core CPI remain well above the Fed’s target.

Inflationary anxiety is also evident in the latest selloff (rising yields) in long-term treasuries. The iShares holding 7- to 10-year maturities are on the verge of breaking below the level it found in February 2007, while the iShares holding 25- to 30-year treasuries already broke below the February 2007 bottom. The tough job the Fed has in navigating the economy between the rocks of recession and the rocks of inflation just got tougher. This being a preelection year, the Fed will be reluctant to be heavy-handed and will rather temporarily accept a higher inflation rate than risk a full-blown recession.