Several years ago, on a flight
into San Francisco International Airport, the pilot came on
the intercom and said, “Ladies and gentlemen, prepare
for the softest landing you have ever experienced.”
And he was correct. Last Tuesday the Fed paused after seventeen
consecutive rate hikes and said that inflation is “elevated”
right now but will begin to decline because economic growth
is poised for a modest slowdown. In other words, a soft landing.
This is not a plane the Fed is commanding. It is a $12 trillion
dollar economy. Years ago economists talked about the Phillips
Curve, an economic theory that postulates a trade off between
inflation and unemployment. “Experts” believe
that economic slowdown (soft landing) will have to be much
more substantial than the Fed expects. Core inflation is at
2.6% now and climbing. Under the trade off theory (Phillips
Curve), the unemployment rate has to rise by about two percentage
points for an entire year to reduce inflation by one percent.
This would result in a loss of about three million jobs. Not
a very soft landing.
The key to the Fed’s future actions then would seem
to be the strength or weakness of the current economy which
ties into the notion that we are at full employment. If we
are, then additional demand for workers will push up wages.
Wages account for more than 75% of total production costs.
If wages rise faster than productivity, we have added inflation.
We believe the economy is stronger than the last reported
GDP numbers (2.5% for the second quarter). Remember, these
numbers are continually revised. Even if the economy is cooling
off, we can still have inflation. Dare we mention money supply
again? The money spigot was wide open in 2004 and 2005 and
accounted for the strong growth we are still witnessing. This
administration’s tax cuts helped boost the economy much
more than most realized, so the additional printing of money
was just adding fuel to the fire. A fire that will be difficult
to contain.
That brings us to housing. There is no doubt that easy money
and low interest rates have led the way in this current economic
boom. But is the bloom off this market? Yes. Is this a bubble
like the stock market in 2000? No. Houses are not like stocks
that can be liquidated in a moments notice. Last we heard
they have not repealed the law of supply and demand. Over
70% of families in America now own their own home –
the most ever. The demand for houses has pushed prices too
high to be affordable for the majority; sales are slowing
and prices are coming down. Builders are dropping plans for
new developments as they focus on selling what they have in
inventory. Many builders are now offering incentives to buyers
such as upgrades, new cars or even vacations. Houses for sale
on the market are still selling, but it takes longer to sell
them. We would not call this a bust, but rather a gradual
decline that will probably take a good deal of time to work
its way out.
So, if the housing market is slowing and consumers are not
taking out second mortgages, what will keep the economy moving
forward? We have talked in the past about the fact that American
corporations have cut the fat and become lean and mean in
order to stave off competition from Asia. Foreign companies
are even moving production facilities to the US. We expect
business investment to take the load off the consumer. Corporations
are flush with cash and that cash will fuel the next boom
in technology. The playing field is starting to level as cost
of production in China is increasing making us more competitive.
In addition, we still have the most skilled labor force on
the planet. The percentage of parts being rejected by Chinese
manufacturers is much higher than in the US. Part of the reason
for that can be found in the difference in our educational
systems. Decades of rule by the Communist Party has ingrained
in their people not to question authority but to do things
by rote. We as a society are always questioning and are much
more imaginative.
In sum, we are very positive about the economic outlook here.
The continuing economic growth may force the Fed to raise
rates again. However, even at 6%, interest rates would only
be at normal historic levels. The only way the Fed can slow
current economic growth would be to choke off the money supply.
Random thought for August 2006:
Socialism: You have two cows. The government takes one and
gives it to your neighbor. You form a cooperative to tell
him how to manage his cow.
Capitalism: You have two cows. You sell one, buy a bull and
build a herd of cows.
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