Wednesday, August 29, 2007


Those who believe Ben Bernake is doing a great job are suddenly few and far between. The calls for an interest rate cut are bouncing off the inner walls of TV tubes across the globe. The CEO of AutoNation says that the FOMC needs to cut by 2 full percentage points to avoid a recession. If times are so tough, why is "Big Ben the Gorilla" still holding the US economy down?

As anyone will tell you, the FOMC can only control the short interest rates. The market controls the price of stocks, the long term interest rate and the value of the US dollar. However, saying the FOMC only controls short term interest rates is like saying that the flood master at a dam only controls how much water he releases. Certainly, the flood master looks at the height of the water level before making his decision and, indeed, if the water level of the lake goes down, he might lower the amount of water he allows to spill over. If the flood master knows that the snow is melting in the mountains, he may increase the amount of water he releases, even though the water level is low.

"Big Ben" has a much tougher job than the flood master. In addition to the water in the "big lake", "Big Ben" must keep his eye on the levels of several series of lakes, including the newest biggest and the overflowing "China Lake". Twenty years ago, and perhaps even five years ago, if anyone had told any economist with a brain that China would grow its economy at an average nominal rate of better than 15% for four years in a row, 2004 through 2007, they would have been laughed out of house and home. How could this be possible? It is not just possible, it is real.

China is on a mission. It wants to do all it possibly can to prepare for the 2008 Olympics. The country has built the equivalent of the entire US Interstate Highway system in the past several years. It has employed 100's of millions of new workers. The magnitude of the growth in China is simply not fully appreciated by most of the people of the world. China has done the impossible because they have been focused on doing the impossible.

The response of the government has been to continue to pull out all stops no matter what. When it became obvious that China could not import enough gasoline to grow so fast, they instituted odd-even days. China cars with license tags that end in odd numbers can only be driven on odd numbered days. The people are getting to work but driving half as many cars. The interest rate push has been less than forceful. In 2003, the Chinese economy was growing at a nominal rate of about 10% with the official lending rate at 5%. The rate finally moved up a small amount after the nominal growth rate had jumped all the way to 15%. The whole next year, rates stayed about the same. Last year, Secretary of the US Treasury, Henry Paulson made several trips to China and Ben Bernanke accompanied him on at least one of these. Since that time, the Chinese have raised their official lending rate many times but always by small amounts. The chart of rates looks like the chart of US rates that were increased 17 times beginning in June of 2004.

Wow, 7% interest and growth of 15%! Have you heard about having your cake and eating it too? The people of China have died and gone to Heaven! The trouble is that it cannot last.

It is mathematically impossible for the growth to continue at such at rate. Sooner or later the law of large numbers must get in the way. The rule of 72 tells us that 15% compounded growth creates a double in only 4.8 years. The Chinese economy has suddenly become the third largest in the world. The strain on resources, including energy resources, has been incredible. Ironically, with the experience of the 1970's in mind, the major oil companies have done an incredible job of meeting the demand. Again, had you told any economist that energy demand would have grown so much in the past 5 years, he would have said that it would be impossible for the market to have filled the supply. He would have predicted shortages and gasoline lines.


One of the many big, very big, misses the market pundits spew out of their mouths is the relationship of short term interest rates to the value of a currency. Think of "Big Ben" as an 800 pound Gorilla sitting on the US economy. By raising interest rates, "Big Ben" has said to the rest of the world, "Hey, guys, we are slowing our economy down!" "This means that we are going to stop importing so many goods from you guys, and fewer of us are even going to come to your country for a visit!" "Furthermore, because our dollar is going to depreciate in relation to yours, our goods are going to be very competitively priced and we will sell more stuff to you even though we will buy less stuff from you!"

Most people focus on money flows and suggest that when interest rates are high that foreigners will buy more dollars so that they can invest these dollars in the higher US rates. What they fail to realize is that the FOMC can soak up dollars like a sponge. On a daily basis, the FOMC must decide how many dollars to create or how many to destroy, the FOMC controls the printing press.

As a result of the tightening by the FOMC, the US economy has slowed and indeed the rate of growth of imports has slowed. China now runs a bigger trade surplus with Europe than with the USA. The increase in US rates put a lot of pressure on other central bankers to follow suit and they have. Australia, for example, shot right past our 5.25% and went in to the 6's some time ago. The ECB has been steadily raising rates and was all set for another increase but is having second thoughts now that credit problems are surfacing.

What about the flood master who controls the water level at "China Lake"? What is this guy doing to control the water? Nothing! There is no flood master in China. China does not control its own money supply. The government has pegged its currency to the US dollar. Therefore, "Big Ben" must operate like a tugboat. He must pull China along for the ride. The problem is that the China boat is too big for him to pull by himself. He must have and he has had the cooperation of other central bankers. So far, he has pulled and pulled and pulled and the world has started to move. All but China.

China is in the middle of a financial bubble. The stock market in China is more over priced than the US market was overpriced in 2000. If the growth rate of all of China is going to remain at 15% or better for many years to come, then I am wrong, the China market is not over priced. But, with local pundits starting to scream as loud as Jim Cramer, saying that the "FED MUST CUT RATES!", "Big Ben" is sitting tight waiting to see that there is movement in China. We should remember, that moving a battleship is easy once you get it started. You certainly do not want move a battleship too quickly in tight waters because once you get it to move it is impossible to stop it in a hurry.


I send you my thanks for sticking with me through this complicated story. I do not know if it makes sense or not. My point is simple; despite the growing chorus of complaints about "Big Ben", I believe he is doing a fantastic job. Moving from a consumer lead expansion to a business prosperity cycle has never been easy. Indeed, historically, up until the 1980's and 1990's, the move was typically accompanied by a recession. This time, the most recent GNP numbers are around 4% real growth. That is after all inflation! The pundits who are kicking and screaming are generally on the wrong side of the market.

Can you appreciate the magnitude of the problem. A tiny move by the FOMC, or the failure to make a tiny move, could easily cause millions of people to starve to death. Those who feed their families during the inflation days of the 70's do not want the FOMC to be too easy again and those who lived through the great depression do not want the government to have all the money.


Many a sign has been posted that the actions of the FOMC are having the desired effect. Indeed, the pain being experienced by hedge funds in the hyper leveraged credit markets is a strong sign that the actions of the FOMC are working for the greater good. One key market indicator is the interest rate on the 10 year treasury bond. Again the typical market pundit gets the relationship upside down and backwards. They expect the long bond rate to rise when the FOMC raises short term rates. The effect is exactly the opposite. When the "Big Gorilla" sits down with all its weight on the economy, the effect is to slow the economy. It is a simple story of supply and demand, when the economy slows, the demand for everything is reduced. The home builder will buy less lumber, less land and he will borrow less money. The home buyer will not take out a 30 year mortgage if the builder does not build a house on a 180 day construction loan. The higher the short term rate goes, the lower the demand for both the short term money and the long term money.

In the past several months, the 10 year rate has fallen. Because the 10 year rate is nothing more than the real GNP plus the inflation rate, one can improve ones guesstimate about the strength of the economy and the inflation rate by studying the term structure of interest rates. In recent days, the market rate for 90 day t-bills has dipped to very low levels. Part of this dip has been a result of the dying demand for construction loans. Which is the cart and which is the horse? Long rates have headed down because the demand for mortgages has fallen, the short rates are down because the demand for construction loans has fallen.

Over time, the FOMC must simply stay out of the way and let the market decide. Much of the time, the FOMC is able to do just that, stay out of the way. In other words, the Fed Funds Rate will normally simply follow the 90 day t-bill rate.

The actions of the FOMC are again a bit like the actions of the flood master. Alcoa finds itself in a similar position on a number of lakes it controls. Alcoa must use millions of gallons of water daily when its smelters are running. If it uses too much, its lakes will run dry and the public will be very upset because their source of recreation has dried up. The 10 year rate is like the water level on the lake. The flood master does not want the lake level to gyrate out of control. The FOMC does not want peaks and valleys in the economy or in the 10 year rate. In a similar period of great demand for natural resources, the 1970's, the FOMC did not have the psychological wherewithal to hold rates high enough to ward off inflation. The ten year rate went up to 15 or 16%. This is when I earned my T-Bond moniker. In hind sight, I was much too timid but at the time, when I borrowed heavily at short rates in order to lock in 14% rates for 30 years, I was going against the conventional wisdom and was perceived to be "off my rocker". Those bonds appreciated 60% over the next few years and the leverage multiplied the move and increased the cash flow.

The lake level is going to be a little bit low for awhile. The GNP will slow from 4% this past quarter to a lower rate by the next quarter and the inflation component of this rate is likely to fall to the low 1% range. With exports growing at better than 11%, it is hard to see a recession in the near future. The lake can easily hold 5% volumes of water. The China Lake has been out grown. The lake has to be expanded. It is the world wide expansion that is causing the temporary problem. When the population and thus demand for goods and services grows, during the recovery phase, "new lakes" do not need to be built. We are now in the later phase of the cycle, demand growth means new capacity must be built.

Those calling for a quick drop in the Fed Funds Rate may be sorely disappointed. Ironically, the price of oil is holding up partly because many believe that the FOMC will "chicken out" early. If the FOMC holds its ground, oil prices will fall. The inflation portion of the 4.58% could easily fall to the 1% area. If it does, the FOMC will have every reason to lower rates. Again, the gyrations of the past are in the past. It is entirely possible that the US economy can transition from the recovery phase to the prosperity phase without another move by the FOMC.

It is too early for the pundits to be calling Ben Bernanke an idiot. An argument that you seldom will hear is that the FOMC is a political animal and that it might be trying to help keep the congress from making damaging changes to the tax laws. Let's not go there but instead lets just hope and pray that no great damage will be done. One of the great beauties of the American system of government is that it is difficult for one party to swiftly swing policies from one side of the middle to the other. Only in times of great stress can big changes be made. The current level of stress is modest at worse. Indeed, throughout much of the history of the USA, we would have been happy to see real GNP of 4%, unemployment of only 4.6%, mortgage rates of 6.5%, prime rate of 8.25%, cash on the books of the average corporation, twenty quarters of double digit profit growth, and inflation of around 2%.

Times are good. Those who buy aggressively now will be very happy a year from now!

Since I have been writing these letters, the only time the numbers have been as positive for future price appreciation was in the fall of 2002 and the spring of 2003.