Why the Fed May Not Believe in Permissiveness

By Ernie Ankrim, Chief Investment Strategist
Russell Investment Group
Global Leaders in Multi-Manager Investing

August 11, 2005

It almost sounds like a bedtime story. The U.S. economy continues to perk along at a very firm rate. Employment is growing. Unemployment rates are low. Inflation is controlled. Profits continue to be strong. Even with recent rises, interest rates continue to be relatively low. And so far, oil prices haven't substantially affected either economic activity or costs.

So in this Goldilocks world of economic activity, why hasn't the stock market advanced more dramatically? Through August 8, the broad market Russell 3000® Index was up less than 3% for the year. With all these encouraging signs, you would think the market would do more.

The fact is, market makers are waiting to know when the Federal Reserve is done increasing the Federal Funds Rate target — the interest rate banks charge each other to borrow overnight reserves. Since last summer, the Fed has increased this short-term interest rate 10 times, moving it from 1% to 3.5% today. By year's end, it's possible we will be at 3.75% or even 4%.

A Little Discipline Can Change Behavior
While these rates are not directly aimed at investors, they have spillover effects to every other interest rate in the marketplace. The Fed is doing this to help keep the economy from overheating; keeping upward pressure on prices is a way to press down on the brake pedal. But the concern is that the Fed might increase rates for such a long time to such a level that it slows the economy too much — causing a turndown in profits and employment.

As long as the Fed continues to increase rates, this risk of overtightening the economy exists. That's why we probably won't see the equity market take off substantially until we have some assurance that the Fed is done increasing these interest rates. When will we know that? The answer — even though it sounds glib — is only after they have a meeting in which they don't increase rates.

Truth is, the Fed won't tell us ahead of time when they're going to be done. They're going to stop when they believe they've eliminated the current threat of inflation that persistent increases in commodities and oil prices might represent, and the additional threat of rapid economic growth putting pressure on supplies of other resources. And they don't know exactly when this is going to happen. Could they guess at it and let us know ahead of time? That might make the markets euphoric, but it goes against the grain of good parenting. Let me explain.

Saying 'Yes' Can Hurt in the Long Term
Now that Professor Portfolio is old enough to have grandchildren, the Grand Canyon, Mount Rushmore and the badlands of South Dakota all seem like beautiful sights to me. But when my Dad would take Mom, my brother and me on car vacations, the time spent on the road looking at scenery seemed interminable. As happens in thousands of families, a steady chorus of "are we there yet?" greeted my Dad from the back seat. But my old man was always too smart to take the bait.

Dad was always reluctant to say, "well, we'll be there in an hour" because he knew that traffic, a bathroom break, an empty gas tank or countless other situations could cause it to be more than that. If he told us it would be an hour, and it turned out to be two, we two boys would be hard to handle. On the other hand, if he told us two hours, and it turned out to be one, we'd be pleasantly surprised.

Back at home, whenever we would ask Dad to buy us something, he'd use the same logic. His first answer was always a 'no' because at worst it would cause momentary disappointment. If on reflection he thought it might be a good idea, he could always change his 'no' to a 'yes' so we'd feel better. But if he first told us 'yes' and later decided it was a bad idea, we would be devastated if he changed his answer to a 'no.'

In Professor Portfolio's world, that's a rule of good parenting. You never reverse a yes, but you can always reconsider a no. And it's likely my Dad knew Alan Greenspan's father.

We'll Get There When We Get There
Right now, the market is asking the Fed "are we there yet?" But the Fed doesn't want to tell the market it is done increasing rates until it is absolutely convinced. The Fed won't say 'yes' until it is certain it has gone far enough to where it won't have to later say 'no.'

If on reflection the Fed looks back and thinks it increased rates a quarter-point too much, it can always cut the rate. What it doesn't want to happen is to stop increasing rates, only to look back six months later at rising inflation and realize it didn't keep the increases going long enough. If the Fed then resumes another round of increases, the market would react in what could best be described as a tantrum.

Like many new parents, the Fed has learned over time the rewards of consistency. From the mid-'70s to early '80s, the Fed tried to use monetary policy as a tool to increase economic growth, continually turning rate increases on and off. That produced an ever escalating inflation rate, rising into double digits. Under Chairman Paul Volcker, the Fed changed its strategy to pay attention solely to controlling the inflation rate, letting unemployment, profits and the GDP naturally go up and down with economic cycles. By focusing 100% on protecting the purchasing power of the currency, Volcker, followed by Greenspan, presided over an unceasing drop in interest rates for the next two decades. This was arguably the greatest 20-year experience of central banking in U.S. history.

And so this market, by most fundamental measures, is undervalued. But until we know that the Fed won't go so far as to take the steam out of the economy, we'll be reluctant to bid up prices to reflect what historically would be a more realistic number. Meanwhile, we may as well stay in the back seat and keep our hands and arms inside the car, because the Fed is going to hold out every opportunity to reconsider its decision before it finally tells us we're there.