It's all about the interest rates...

I've been saying for some time now that June would be the month that we'd see attitudes shifting. While I would normally have been happy to have seen my prediction come true in May or July I am ecstatic to see that I hit the nail on the head with this one. Economists don't know how much or how fast rates will rise but they are almost unanimous in their agreement that 25 points are coming on June 30th.

Contrast that with the beginning of the year when people were talking about how the Fed still had "ammo in the gun" in case they needed to spur the economy on even moor. The American economy is an amazing machine and it is now beginning to ramp up for another recovery.

I think some things are important to keep in mind:

1) While Greenspan has said that oil prices are, "troubling" I believe that they have no direct impact on fed policy. Consider also that any rate increase will generally strengthen the dollar after the hikes stabilize thus decreasing oil prices. People flock to the highest rate of return and the primary reason that the dollar has tanked so bad is that the European Union has (irrationally) kept their rates higher then ours (that's not to say they should move in lock step with us but when we're at 1% and they're at 2.5% and we're sharing in the same recession then you can only conclude they're being irrational).

2) More alarming for fed policy is the deficit. The deficit is financed by increased issuance of treasury securities. Flooding the securities market tends to spike rates all by itself (remember, price of treasuries moves opposite of rate). So the deficit is a brake on the economy. With the deficit rising so high see Chart VII on page 4 I would expect the Fed to back off rate increases a little sooner then they otherwise would.

3) "Slack Resources" is a term that the Fed has bandied about for almost 2 years now. Essentially, what they're saying is that American companies have untapped or underutilized resources that they can turn on in the event of rising demand. These aren't just raw resources either. We're talking about production lines, call centers and retail locations that are shutdown or understaffed. Furthermore, there's a flood of business investment occuring right now that won't have a tangible affect on the economy for 2-3 years. For example, look at Eckerd's Drug Store. They are in the process of changing their business model from being tenants in strip centers to being land lords of their own property. This shift is expensive up front but will reap millions of dollars in rewards as they pay 4% fixed rate mortgage loans instead of rent and in the future when they have equity to tap into to generate cash.

4) I don't know what internal metaphor the fed uses when they talk about interest rates. They talk about "priming the pump" but that is inadequate. The metaphor they should be using is that of a car with an accelerator and gas pedal. Their job is to keep the car going at some speed (4% GDP growth) and their primary tools are interest rates (they have a couple others but they don't generally use them). Many people think that a rate increase is a brake on the economy and a rate decrease is tapping the accelerator. Nothing can be further from the truth. The fact of the matter is that the fed could raise rates 200 points tomorrow and they'd still be pushing the accelerator. The way people really need to think about it is that somewhere between 3.5% and 4.25% (noone knows for sure) the car is coasting. Anything below that and the fed is pressing the accelerator and anything above it then they're leaning on the brakes. Using that allegory, you can see that the Fed has been REALLY mashing down on the accelerator. I think they'll be pretty quick to let up to 3.00% or so... then they'll be very slow and deliberate after that. People forget that a "measured" approach doesn't mean slow it means steady. They won't be spiking rates all at once but they will make as flat a line as they can. I would expect that whatever rate they begin raising rates at is what they'll stay at.

One last thing. Now that the recession is largely over you don't see alot of people asking this question but I think it's a very important question, "How close did we come?" It's fairly obvious that the economy didn't have a collapse like it could have had. Increased government spending and sound fed policy steered us clear. But how close were we?

Consider that we had year over year deflation in the PPI in 3 seperate months during this recession. Core CPI showed month over month deflation twice. The fed lowered rates as much as they could (as Japan proved there truly is a liquidity trap and you hit it somewhere just under 1.00%). Our deficit is about as high as it can be without having an abrupt braking affect on the economy (I always thought that one of the great ironies of fiscal policy is that deficits are short term stimulus long term restraining affects). The dollar is the weakest it's been in a long time. My perception is that we were on the brink of tipping over and that we were held back by some quick decision making and some luck. Only time will tell though.

Predicting rates 6 months out is a gamble at best but I'm going to say that they'll be 2.00% or 2.25% at the end of the year.