"Greenspan: Call an Audible"

09/09/2005 12:00 am EST


John Mauldin

Chairman, Mauldin Economics

"All eyes are on the terrible devastation caused by Katrina," notes John Mauldin . "But as investors, we must look at the economic implications, and how they fit into the larger picture, specifically Fed policy." Here's his sage advice to Alan Greenspan.

"One of my favorite moments in Dallas Cowboy football was when Hall of Fame quarterback Roger Staubach would come up to the line, see the problems in front of him, and call an audible. (That means he changed the play at the last second, shouting out a code for a new play.) Let's see if I can make a case where Fed quarterback Greenspan needs to come to the next Fed meeting and call an audible.

"Unemployment reportedly just fell to 4.9%, its lowest rate in four years. Now, up to one million people will be without jobs due to Katrina. While this is temporary, it is going to mean a big loss of consumer spending power in the short term. And yes, the reconstruction is going to pour a lot of spending into some industries, but it will not be for several months at the very least.

"Meanwhile, US consumers spent more than they earned in July for just the second time in the last 46 years. As a result, the personal savings rate tumbled to negative 0.6%, the lowest since monthly records began in 1959. My guess is that this is going to get worse as energy costs force families to adjust and dip into savings in the interim. This is clearly a condition that cannot continue. And yes, I know that the rate does not measure asset growth and other forms of savings, but it is a useful historical indicator of actual spending habits.

"Without going into details, as everyone now knows the centrality of the port of New Orleans, and if the Mississippi is not opened up for shipping, and the docks and ports are not cleared for loading and unloading, it is going to be a major hit to US exports and business, especially agriculture. While the shipping lanes will get fixed and the docks put back in working order, there is no realistic estimate of how long that will take. Weeks? Months? There is a lot of uncertainty.

"It is going to take months to sort through the issues at stake for businesses in the region. The good news is that America’s small- and medium-sized businessmen have spent all their lives figuring out how to solve problems that threaten the survival of their business. That is what makes America so great. American entrepreneurs are some of the most resourceful and resilient anywhere. While this is more than many have faced, my bet is always on the entrepreneurial spirit.

"In critical industries, like shipping, the government should step in with quick loans and grants to get things moving and then get out of the way of the business owners. Let them figure out where and how to actually solve their problems. Get them the tools and money and watch how fast things work. But fast is a relative term. It will still take weeks and months.

"The estimates of how much all this is going to cost are all over the board. A leading catastrophe risk-modeling firm, Risk Management Solutions, said that Katrina and the flooding of New Orleans would probably cost more than $100 billion in total economic losses. In the grand scheme of things, that is less than 1% of US annual GDP. That is one reason why most economists do not think Katrina will push the US into recession. And if we were just dealing with Katrina, and not with other issues, I would tend to agree, again assuming shipping lanes and energy supplies are restored within a month or so.

"But, we were already seeing things begin to slow down because of high energy one million temporarily unemployed people (read, consumers) cut into GDP for the third and fourth quarter? Estimates range as high as 1% for a few months of time. Now, in an economy rolling along above 3.5%, this is a problem but not a recession, but it does take you in the wrong direction.

"Meanwhile, inflation is already at the upper bounds of what the Fed is comfortable with. Several recent speeches by Fed governors have highlighted this point. And they are right; it may be creeping up. In spite of the Fed raising rates, housing price increases have not slowed down. If allowed to continue, it could create a real problem when the bubble begins to leak. And Fed members are very aware of that. Hence, Greenspan's clear warning last week.

"Further, there are those who make the argument that when the Fed failed to respond in the 70's in the last supply side oil shock, and eased aggressively in the face of an oil shock recession, it brought about stagflation. And they have a very serious point. If inflation is allowed to come back, even in the face of a recession, we could visit the 70's all over again. But that is a big ‘if.’

"Put in layman's terms, if you believe the Fed is going to lower rates, you are better off actually taking the lower long-term interest rates, because they are going to go even lower and you can make a profit as rates go down as well as get more for your cash today. So, let's cut to the chase. We will certainly not be able to assess the short-term impact of Katrina by the next Fed meeting. And even though inflation seems to be pushing upwards, Katrina may reverse that trend. We just don't know.

"If Greenspan continues to raise rates slowly, the market knows that it will eventually hurt the housing market as well as bring on an inverted yield curve and a recession, which is what the Fed has always done. They always go too far. The market will anticipate this and invert the yield curve for him, perhaps aggressively, making long rates lower and doing the opposite of what Greenspan is trying to do. Mortgage rates will drop and housing prices will rise. Things get weird.

"Further, the collective wisdom of the market is telling Greenspan that he should wait. Fed fund futures are pricing in only 25 basis points of rate hikes this year, as opposed to 75 basis points it priced last week. The market is screaming for the Fed to slow down. And let me mention the unthinkable. The National Weather Service suggests we may see four-five more hurricanes this season. Who knows where and how strong? It might just be prudent not to tempt fate.

"Quarterback Greenspan should come to the Fed meeting September 20 and, like Roger Staubach, call an audible. He now has the perfect excuse. They should not raise rates, announcing that they would like more time to assess the effect of Katrina on the economy. There is no need to rush when there is a lot of uncertainty. Between now and the next meeting, the Fed can begin to lay the framework for a specific pause in the rate hike process. Transparency is important.

"My bet is that the US economy will weather Katrina and that my Gulf region neighbors will get it going again. But it is not certain. Greenspan's own rule is that central banks must first make sure they do no harm and avoid the most negative of outcomes. Housing prices rising another 1% in the 40 days between meetings is not a huge negative or risk. Getting us to an inverted yield curve when there is a reasonable (though not probable) risk of an energy shock is a very negative outcome. Mr. Chairman, make like Roger. Call an audible."

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