Fed watching is a normal and necessary part of Paul Kasriel's job. As director of economic research for Northern Trust Corp., Kasriel is responsible for the firm's official forecasts for economic growth and inflation. Lately, Kasriel doesn't like what he sees: a worsening of the tradeoff between economic growth and inflation, caused, in part, by the Federal Reserve's aggressive rate cuts this year.
Just two years ago, gross domestic product (GDP) was growing at a 5% clip while the inflation rate was a very tame 2.6%. Last year, the two indicators both registered gains of 3.4%. This year, Kasriel is forecasting a 3.3% inflation rate but economic growth of only 2.1%.
As one who had grown weary of "Greenspan glorification" at least a couple of years ago, it's refreshing to hear the views of someone else who isn't a total Greenspan diehard. According to Kasriel, the reason we've found ourselves in this economic slump is because the Fed let the boom of the late 1990s get out of hand. Although Greenspan warned of irrational exuberance in late 1996, the story "didn't play well in the press" and the Fed chief dropped that notion in favor of remaining popular. The boom had advanced too far by the time the central bank started hiking rates in 1999.
"I think the Federal Reserve basically aided and abetted a stock market bubble and a capital investment bubble," charges Kasriel. "People were able to raise funds at artificially low costs of capital, to invest in all the dotcom silliness, and this was all because the Fed was holding interest rates too low. When the Fed finally decided to try to deflate the bubble a little, it burst. Now, Alan Greenspan has bubblegum all over his face, and he's desperately trying to re-inflate."
According to Kasriel, we're now faced with a number of negative consequences of the boom-bust cycle that litter the road to equilibrium. In addition to the untold carnage that resulted from overzealous spending in Internet and telecom ventures, the unbridled obsession with one economic sector contributed to resource shortages in other sectors. Energy is one case in point.
"So much excess capital was going into technology, where the expected returns were very high, and far too little capital was going into energy, where prices were still low," says Kasriel. The combination of too little investment and growing demand inevitably led to shortages and rising prices.
"We basically shied away from energy investment ever since the mid-1980s when an oversupply of energy caused OPEC to fall apart and oil prices to collapse," notes Kasriel. Not only did oil drilling screech to a halt, but resources also stopped flowing into alternative power development such as nuclear and even coal-burning plants. Meanwhile, the economic surge of the past decade translated into enormous needs for energy.
The displacement in resources has resulted in a dichotomy of huge layoffs in certain sectors of the economy and severe labor shortages in energy. The skills needed in energy production aren't the same as those used in the waning sectors. "I've heard of oil drillers waiting outside Texas prisons trying to recruit parolees who know anything about oil drilling," says Kasriel. "There's also a shortage of coal miners, but you're probably not going to see a lot of dotcommers going to Appalachia to work down in the mines. This shortage of labor creates bottlenecks in the economy and puts pressure on prices."
Not surprisingly, higher energy prices have attracted more capital investment. Kasriel's recent energy report indicates that first-quarter 2001 investment in oil- and gas-drilling structures soared to an annualized rate of $48.7 billion, a 74% increase over the year-earlier pace and the greatest hike since the early 1980s.
"While most economic commentators are gnashing their teeth about rising energy prices sapping the lifeblood of households and businesses, they forget that the money we send energy producers and distributors each month does not disappear under mattresses," Kasriel writes in a recent economic report. "Rather, because energy prices are now up to levels where it is profitable to go out and explore for oil and gas, extract it from the ground, refine it and distribute it, that's exactly what energy producers and distributors are using our monthly payments for."
Kasriel's current gripe with the Fed is that he believes it's interfering too much with natural pricing mechanisms. Because the Fed is lowering interest rates so much and so fast, Kasriel contends that we'll end up with an oversupply of money that will result in overspending and higher inflation.
Kasriel calculates that the M2 measure of money supply escalated at a 13.6% annualized rate in the three months following the start of the aggressive rate cuts. Since higher money-supply growth tends to result in GDP growth after a couple of quarters, the odds of stronger GDP growth in the second half of this year look good.
What Kasriel fears is that Fed pumping has gotten carried away. Evidence of higher inflation is cropping up in various locales. In another economic report, titled "Yo, Kudlow-Why Are Gold Stocks Suddenly Glittering?," Kasriel points to rising gold and gold-stock prices, the steepening of the yield curve, increases in single-family housing starts, and the yield spread between traditional Treasuries and TIPs as indicators of rising inflation. "And, oh yes," muses Kasriel, "annualized CPI growth in the first four months of this year was 3.8% vs. 3.4% for 2000 and vs. 2.7% for 1999."
In its May 15 report that accompanied the fifth rate cut for 2001, the Fed projected that inflation will remain under control. Kasriel's reaction? "It is not clear how this is a credible projection given the recent escalation of consumer prices and the age of the expansion that has put a severe strain on resources (energy is a case in point.) Although the Fed left the door open for additional rate cuts, they are likely to find themselves in a tight corner as the threat of further gains in prices looms large. ... If we are correct, the Fed may have to reverse the monetary pumps come early next year."
It's impossible to resist asking Kasriel his views on Greenspan's tax-cut posture. "I thought it was manufactured. I find it very interesting that in 1993 when a Democrat came into office, Greenspan suddenly was in favor of tax increases. But when a Republican comes into office, he quickly comes up with very interesting arguments for tax cuts. Now let me say that I'm always in favor of cuts in marginal tax rates, but Greenspan's stance just seemed like a remarkable conversion."
Now Kasriel is on a roll. "We keep saying that we don't save enough. So why didn't Greenspan come out in support of using the surplus to privatize Social Security? He's been in favor of that in the past, but he never once mentioned it in the recent tax discussions."
Any closing jibes, I ask? Kasriel's enthusiasm jumps to a new level. "People say that the Supreme Court reads the election results," he proffers. "Well, so does the Federal Reserve Board. If Greenspan had any sense, he would have left as soon as Bush was elected and let the new president name a new chairman. Actually, he should have left in early 1999. Michael Jordan left at the top of his game. Why hang around until your only remaining course is downhill?"
Mimi Lord, CFA, CFP, is senior editor of www.morningstaradvisor.com.