Fed May Be Looking in the Wrong Direction

Mike Norman
Back in August when I was on "Bulls & Bears" I predicted that the Fed would continue raising interest rates and the Dow would be down 10 percent by year’s end. Since that time there have been two additional rate hikes and the widely followed index has shed some 300 points. While we may not make it to 10 percent down by year’s end, I am no less gloomy about the market’s prospects now than I was then.

Many things have come together that seem to suggest a difficult environment for stocks in the near term. I mentioned the Fed, which, if anything, seems more intent than ever on pushing rates higher. As a result we’ve already started to see some impact on the housing market with both home prices and mortgage applications falling.

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Rate hikes aside, there are other problems out there that pose a threat to stocks too, such as skyrocketing energy costs. After Hurricane Katrina gasoline prices surged because of damage to rigs and other vital energy infrastructure. Now, with winter fast approaching, forecasters are saying that heating costs could rise sharply. That would be the equivalent of a one-two punch.

The big problem is that real disposable personal income is going to take a hit. That’s bad, because 70 percent of the U.S. economy is driven by personal consumption, so increases or declines in disposable income are big determinants of consumption trends. Consumption drives economic activity, which drives business profits, which drives stocks. You get the idea.

In trying to look for something that would offset what is happening to income I am hard pressed to find anything. Tax cuts would be nice, as that would put money back into the hands of households and businesses and they could spend more. Tax cuts would make me very bullish on stocks. But you can forget it for the simple reason that politicians say tax cuts would worsen deficits. (Perhaps that’s true in the short term, but stronger growth would boost revenues and deficits would come down. We’ve seen it.)

How about the big increase in government spending that will be necessary to rebuild New Orleans? Even the Fed says that’s a fiscal stimulus, so it should be a positive, right? Yes, except for one problem — Greenspan is committed to fighting that "fiscal irresponsibility" (read: stimulus) with higher rates. (Thanks, Alan!) And finally, both Congress and the president are looking for spending cuts to offset the cost of rebuilding. In other words, much of the stimulative effect will lost.

Rising rates and slowing income growth are not the only problems facing the market. The recent surge in corporate bankruptcies is ominous because, despite all the talk of inflation, these events are powerfully deflationary. Bankrupt corporations fire workers or cut their wages and salaries, idle plant capacity and sell products and equipment at fire sale prices. In an economy where debt is both prevalent and historically high the potential for a debt-driven deflation is also high, particularly with the central bank looking in the wrong direction.

Mike Norman is the founder and publisher of the Economic Contrarian Update and a frequent guest on the Business Block.