To The Federal Reserve: Start Raising Interest Rates

The Federal Reserve should have set its "federal funds" rate at 0.25% at its last meeting. Unless there is a marked reversal in the economy, it should raise the rate to 1% in steps.

Confidence in the Federal Reserve is near zero at this point. We have had two major asset bubbles in less than a decade. While there were other reasons for the bubbles, the main reason the bubbles grew to catastrophic proportions was the failure of the Federal Reserve to raise rates quickly in response to the bubbles. True, there should have been better oversight of the mortgage industry and the derivatives based on it. But when an economy as a whole inflates unreasonably, it is the money supply and interest rates that need to be controlled.

The Board of Governors of the Federal Reserve current policy is to "maintain the target range for the federal funds rate at 0 to 1/4 percent." [See August 12, 2009 Federal Reserve meeting release]

One of the causes of the crash of 2008 was inadequate consumer savings. Because most consumers had little of no savings, when credit was reduced they had little or no ability to keep consuming.

Since the Fed lowered interest rates to deal with the crash it should have prevented, those who did save by putting deposits in CDs and saving accounts have been severly punished. True, they may be happy that they were not invested in stocks or speculating in real estate, but as time passes the punishment becomes more real. It must be particularly gauling to get a notice that you credit card interest rate has been raised to over 20% from the same bank at the same time your CD renewal rate is lowered to 0.5%.

There is something obviously corrupt, and diverging from free market pricing doctrines, when the Fed is lending to banks (at the discount rate) without charging interest, and the banks are turning around and charging over 20% interest to the citizens of the United State.

But if you can, forget about justice for a moment. Consider the economic implications of the Fed's current policy. Money costs nothing to those borrowing directly from the Fed. What are the chances that free money will be allocated in an economically efficient manner? Zero, the same as the interest rate.

The biggest problem, however, is that the Fed is signaling that it does not care about inflation. With global supplies of oil, grain, and other basic commodities likely to tighten quickly once the global economy starts expanding, the danger of inflation from commodities alone is high. In addition, the Federal deficit and debt are huge indicators of potential inflation.

It is unlikely that a Fed funds rate of 1% would derail a recovery, even if such a rate had been announced in August. Putting 1% gradually into place is no danger at all. The danger is that the Fed will, yet again, get behind the curve and then be forced to overreact. The even greater danger is that the Fed will get behind the curve and then fail to ever catch up without causing a crash, as happened in 1999 and 2007.

Even if the economic recover is gradual, there is no reason to have rates below 3% by the end of 2010. High interest rates reward savings. That is not just putting money in a savings account. That is thrift, doing things efficiently, doing without waste or luxury. High interest rates also punish borrowing, which is associated with economic inefficiency and waste.

You can let the Federal Reserve know what you think at Federal Reserve Feedback.

Have We Hit Bottom Yet?

What every investor wants to know: have we hit bottom yet? Business people want to know that too. Should we lay off more people, buy that new ERP software, or cut that dividend?

Smart people will use a cover your bets approach. We have already seen a number of worst-case scenarios starting in 2007.

Typically, in the post-Depression recessions, the stock market averages started recovering before the rest of the economy. Stock markets are believed to be forward looking. But that may not be the case this time.

There are a number of differences between this recession and prior post-New Deal down cycles, and a number of similarities. Sorting them out may not tell them if we are at a bottom yet, but they can help us understand how to get our footing once there is a bottom.

Fortunately, many major corporations were cash rich going into this downturn, and are well-positioned to weather anything thrown at them short of the collapse of civilization. Some are taking advantage of their cash positions to buy assets cheap, which is what I believe investors with cash coming in should be doing right now.

Most people who are losing their jobs are getting unemployment compensation. More than any other New Deal reform, this tends to put the brakes on recessions.

The big obvious problems, of course, are banks and housing. The Federal Reserve System was set up to deal with banking credit cycle issues. Unfortunately the Fed is run by people, and in particular it was run for a long time by a certifiable idiot, Alan Greenspan. Alan drank the Free Markets are God kool-aid. If free markets were not sometimes a problem, we would not have needed the Federal Reserve in the first place. Free markets are not magic. They have their own mechanics, and don't care too much about human beings.

It is a tribute to the resiliancy of capitalism, the safety valves and safety nets of socialism that have been grafted onto it in the United States, and the good sense of most business persons that the crew of the likes of Alan Greenspan, Robert Rubin, Bill Clinton, George W. Bush, et al, actually did so little damage to our economy.

I am glad the American people, as a whole, started saving more money in 2008. Even though it hurt the holiday shopping season, even though it hurt the auction prices of some of my stocks. It was the right thing to do. Shopping on credit that has to be paid at high rates of interest is no way to run a family economic unit, and no way to run an economy. Lowered household debt as we go into 2010 will mean people will be paying less interest, and have more actual money of their own to shop with. I just hope we all remember this lesson.

Housing remains an interesting dilemma. As far as I can tell, there is no longer a surplus of housing in the U.S. as a whole, though some areas remain overbuilt, like the central California valley. If the banking system starts functioning in a healthy manner, surplus of houses for sale right now will shrink throughout 2009. In 2010 new home construction will become necessary in at least some areas. That in itself should get the economy back to normal.

But I don't feel the bottom under my feet yet. One more part of the down cycle has not really kicked in, and it could force us further out into the stormy seas. This is the bankruptcy cascade. Businesses can fall like houses of cards when this cycle starts. A business that seems solvent, with plenty of receivables to use to cover its payables, can be put in jeapardy if its receivables disappear in customer bankruptcies.

On the other hand, this is also a healthy, important part of business consolidation. Week, poorly managed businesses with insufficient profit margins or cash reserves get punished. Well-capitalized companies get a licking, for sure, but they can then pick up any paying customers of the losers and enter a new expansion cycle.

This is a stock pickers market. If you are in index funds, you are a fool. The only stocks worth buying now are those with large cash reserves built from profitable business practices. Those cash reserves stand for conservative management. They represent past profits, and they are the ticket to future profits.

Today Gilead (GILD) [I own Gilead stock] announced it will buy CV Therapeutics (CVTX). Gilead is your prototypical well-managed company. Even after it buys CV, it will have a huge cash balance. That's the way to do it.

Keep diversified!

A Best Case Economic Forecast

What am I doing saying this recession might be shallow and short? After all, I'm known as a doom and gloom kind of analyst. Does a company have a flaw it is hiding? It is my job to find it. I warned investors of the Internet stock bubble back in 1999, I even resisted my wife's plea to buy more California real estate in 2003-2005. I called oil prices a bubble in March this year (See Oil Bubble to Burst, March 11, 2008).

On the happy side, I do sometimes conclude that a particular stock may make more money than other investors think (Stocks covered by William Meyers). So I am doing this rosy economic forecast as an exercise. It is not a prediction.

It is always good to look at history before acting too certain of the trends based on current details. In American history the economy has gone back and forth between expansion and recession dozens of times. While there are non-American historic examples of total economic collapse, they are almost always due to wars, not to peaceful economic activity. So the question is not whether the nation will come out of a recession, but how deep it will be and how long it will last.

The current consensus is: deep and long.

The questions that needs to be asked are: what feeds the downward spiral, what breaks the down trend, and what starts a new upward spiral.

How did we get here? What broke the upward spiral of 2002-2006? What started us down?

It is generally accepted that the stock market was not to blame. We had a typical crisis of over production, concentrated in one sector. This was combined with a price bubble in the same sector, housing. After housing prices peaked and investors started trying to find real home owner types to unload their investments on, it became obvious to increasing numbers of potential homeowners that: 1. houses were not necessarily a good short-term investments and 2. by delaying making a purchase, they could save money.

The downward spiral of house prices corresponded with layoffs in the housing and real-estate industry. The rest of the economy was immune for a while, and if the finance crisis had not hit probably would have pulled us through without a recession. Aggravating the situation, however, was a bout of inflation, notably in the price of gasoline. This summer we saw the credit markets dry up as the bright-greedy-boys were forced to deleverage their bets. All this could have been prevented if Alan Greenspan, as Federal Reserve chair back in 2004, had paid more attention to the real economy and had spent less time kneeling in adoration at the great god Free Markets.

Now we have declining consumer spending, increasing unemployment, and a slowing world economy. The Fed is giving banks extremely-low interest rate loans but the banks are not lowering interest rates to the rest of us. Yesterday the sharks at Citibank even announced they were raising interest rates for their credit card customers.

Let me show you how to get a rosy scenario out of that.

First, Americans are saving more. Don't think of that as someone putting $100 a month into a credit union savings account at 3% interest. Think of it as millions of people who are lowering their credit card balances by $100 to $500 per month, and who are paying 20% a month in interest and fees. At our high end, after only four months a family has $2000 less in credit card debt than they would have had otherwise. Just from that $2000 in "savings" they are now going to save $400 per year in ineterest for the rest of their lives, money that would have gone to CitiGreedyCard. They have effectively given themselves a large raise.

Likewise, suppose a family realizes it now costs less to buy a home, in the long run, than to rent. Instead of buying a McMansion they buy something reasonable, a home built back in the 20th century. They start paying off their new 30 year mortgage. They build equity, remembering the lessons of 2007, and never touch that equity. Pretty soon rents have gone up, but they have that same monthly mortgage payment. Life looks good, and they have more cash to save or spend.

Throw some fuel on the fire: lower gas prices. While they are no lower than a year ago, and so won't really help, at least they are not sucking the blood out of the American consumer like they did for the past year.

The soup is looking good now. The Federal Reserve is trying to pump at least enough credit into the economy to allow people who are credit worthy to get mortgages on the homes they want. Unemployed people are milling around in large numbers, eager to find productive jobs.

As best as I can guestimate, we don't even have excess housing stock, on the whole, in the United States today. Every year many houses are lost to fire and other construction. Every year more immigrants arrive (want to solve the housing crisis in a few months? Let anyone on the immigrant waiting list who has the money to buy a house into the country immediately). The home construction industry has slowed way down lately, so as soon as mortgages can be obtained easily, the glut of new, empty housing should dry up in a few months [except in the Central Valley of California and a few other truly over-built areas].

Given all this, we could still see a thawing in the economy in time for Holiday shopping, although I would expect even a rosy scenario would have a flat period into 2009 before an actual expansion resumes.

Heck, maybe I'm not Mr. Gloom and Doom after all. Maybe I am just being realistic.

In any case, all investments (and not investing, too) carry risks, so ...

Keep diversified.