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SMITH AFFILIATED CAPITAL CORP.
Fed 101
March 30, 2006
SA
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LESSONS IN GRAMMAR AND JUDGMENT, NOT INTEREST RATE MODELING
The Federal Open Market Committee issued its 15th consecutive hike in the Fed Funds Rate, to 4.75%. Real Fed
Funds rate now exceeds the core PCE index by 300 basis points; the 10-year average is 220 basis points. The Fed
left a key statement unchanged: “some further policy firming maybe needed.” In our commentary of March 27,
we stated that “a statement that has no language change is paramount to another 25 basis point hike (to 4.75%).”
Although the wording was in line with expectations, it did imply that inflation data was likely to become more important in the coming months. The statement “potential upside to inflation from energy and resource utilization”
was changed to “possible levels of increase in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.” The sentence added the words “and
other commodities,” implying that FOMC staffers are worried not only about energy prices, but increases in base
metal prices. This reiterates our long standing belief that we are in a bull market, not in stocks, but in commodities. At the end of the day it’s whether any of these increased price pressures have seeped into core inflation, and
to that point the most important FOMC inflation comment was “energy and commodity prices have exerted only a
modest impact on core inflation.”
The only substantive changes to the FOMC statement came in the paragraph discussing changes in 4Q’05 and
1Q’06 GDP growth. They had described recent growth news as uneven, suggesting weaker fourth-quarter growth
due to “the impact of Hurricane Katrina and the end of aggressive vehicle sales promotions.” They noted that
growth appears likely to moderate to a more sustainable pace without connecting it to further Fed tightening.
If as the Fed states growth slows toward trend, then the only remaining question is inflation. We draw four conclusions on inflation that we believe will either halt the Fed or permit one more increase to 5% at the May 10th policy
meeting:
1. Excessive business pricing power is not existent. The Philly Fed Index prices paid dropped over 13 points in
March to 17.2, its lowest level since August 2003. This metric has dropped 50 points in 5 months.
2. Import inflation: ex fuels the year over year trend growth slowed to 0.8% from 0.9% in January and off the
peak of 3% set in January 2005. This is lowest pace since October 2003 when the Fed funds was at 1%.
3. Productivity growth: According to San Fran Pres Janet Yellen the drop in productivity would force unit labor
costs to rise. The trend has turned not in favor of the Fed’s call but in the other direction at 2½%, with GDP
running at 3½%. Productivity now accounts for over 80% of the over all growth in the economy. This is a
strong indication of why the Labor Department will never print a Non Farm Payroll of 300,000 plus jobs
again. With wages and benefits contained, labor costs have slowed from 3.4% growth year over year in 2004
to 1.3% at the end of 2005.
4. Housing market risks continue to add deflationary pressure. Housing in some areas of the country has dropped
off considerably. The effects of housing wealth leveling out, combined with rising debt service costs (owing in
part to the re-pricing of variable rate mortgages) should slow consumer spending.
The minutes from this meeting, to be released on April 18, are likely to reveal more than past minutes have shown.
We believe this because it was the first meeting for Ben Bernanke as Fed Chairman as well as two new FOMC
board members appointed by the Bush Administration. It was also a two day meeting which should give more in
depth discussion beyond current conditions in the market. Going forward there are 13 new data points the for the
Fed between April 3rd and the May 10th FOMC meeting. At the tail end of its current policy shift the Fed is now
more data dependent than ever, which will introduce more, not less, volatility around the forward economic data.
— Matthew J. Smith, Vice President
800 Third Ave., New York, NY 10022 • TEL: (212) 644-9440 • FAX: (212) 644-1979 • www.smithcapital.com • E-mail: [email protected]
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or a recommendation of any particular security, strategy or investment product. Such opinions are subject to
change without notice. This publication is distributed for education purposes only. Information contained herein
has been obtained from sources believed to be reliable, but not guaranteed. Forecasts are based on propriety
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