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Past Commentaries

Current Commentary, Review and Outlook
October 1, 2005

To My Clients, Friends & Observers:

The Federal Reserve properly fights inflation but it may be attacking the wrong flank. Throughout the ‘90’s we experienced inflation in financial assets. That passed with the new century. Now we have inflation in real estate assets. Inflation is like Faust, always lurking, always menacing, surfacing here or there, wherever it has the opportunity. The Fed has raised the funds rate 11 times, from 1% to 3 ¾%, ostensibly to fight the bubble in the real estate credit markets. In a prior commentary I pointed out that the last time the Fed was tightening, 1999 to 2000, the price of oil was rising and, coincidentally or not, the world slipped into recession, a condition not the exclusive liability of the United States but no less uncomfortable.

Money supply M3 has increased 6% year-over-year, roughly double the GDP growth rate of 3 ½%. That is clearly inflationary. The Fed is intent apparently on getting lending rates up at banks and having enough leeway to cut rates at the next slowdown. To slow inflationary money supply expansion and discourage speculative lending, the Fed could raise the required reserve ratio of banks (from 3% to 4% on lesser deposits and from 10% to 12% on larger deposits). In his regular reports to Congress the Fed chairman might challenge Congress to legislate against inflationary, speculative lending, like 125% loan to value, or interest-only loans with five-year balloons and adjustable resets. That would be politically courageous and therefore unlikely.

In short Fed actions seem ineffectual at best and actually inflationary at worst. The inflation we are only beginning to experience, and that the Fed is powerless to prevent, is being exported to us in skyrocketing basic material costs: oil/energy, metals and lumber. Prices are being inflated by growing demand abroad though we’ve done little or nothing to mitigate them here; no new drilling nor refining, little or no new mining, restrictive timber harvesting, an epidemic of NIMBYism everywhere, in fact Not In Anybody’s Back Yard, anywhere. The commodity cycle does not peak and valley in a year or two. It has been long in the past and I fear this one has just begun. Everything that is composed of and by energy and raw materials will inflate in price.

In light of the U.S. negative savings rate and still-expansive monetary policy the dollar has remained surprisingly strong. The Euro has fallen to $1.22. The dollar remains the safest game on the planet. This is important to us because inflation or a cheaper dollar has the same effect of reducing purchasing power.

The third quarter ended yesterday and it was a positive period. Standard & Poors predicts that the S&P 500 Index of companies will post all time record profits and will turn in the 14th quarter in a row of year-over-year, double-digit gains (in operating profits). This reflects continued productivity improvement. The question is, are productivity gains decelerating? The reason employment gains in the manufacturing sector have been so anemic is the increase of automation and productivity, not because we are manufacturing less.

Also yesterday, China celebrated its 56th anniversary of Communist rule. Over 65% of the shares of Chinese companies are owned by the government. Who in their right mind would invest in such companies?

Preserving purchasing power is the first goal of every portfolio. Recently I prepared retirement cash flow analyses for some clients and increased the inflation parameter from a default of 3% to 6 ½%. Such an illustration will get your attention, deservedly. Portfolio returns are meaningless if the money’s no good. Most people younger than I – and most seem to be younger than I – do not remember the inflation of the 70’s. A generation of fixed income retirees was wiped out in five years. I will never forget it. Social Security became a living wage.

What is tolerable inflation? At 3 ½%, the cost of living doubles in 20 years. For someone retiring at 65, with an actuarial life expectancy of 84 years (half live more, half live less), that is probably tolerable. At 7% inflation, purchasing power is cut in half (cost of living doubles) in ten years, most likely intolerable for a 65-year-old retiree.

Fighting inflation remains the most important job of the Fed and it is incumbent on us to protect ourselves from it. Feel free to utilize the financial planning services we offer.


 
Best regards,
 
 
Dennis M. O’Connor