Are the Financial Markets Fighting the FED?

As the US equity markets have been in festivity over the FRESH historical high due to “lower inflation outlook” while simultaneously bidding up equity values in view of more “inflation”, the dichotomy is that Fed officials have been in palpable chorus to admonish about the risks of growing inflation.

Federal Reserve Vice Chairman Donald Kohn recently warned investors of underestimating inflation, ``Don't sell the Fed's concern about inflation short...Further upward movements in inflation would be very adverse to the economy and would, I think, require policy actions.'' Mr. Kohn further notes that his concern is more to the side of inflation than of a sagging economy, ``The risks to my outlook for economic activity may be skewed to the downside, while those to my forecast of gradually declining inflation are tilted to the upside,'' Kohn said. ``In the current circumstances, the upside risks to inflation are of greater concern.''

Charles Plosser, newly installed president of the Federal Reserve Bank of Philadelphia, likewise used his inaugural address to tackle on inflation risks. He commented that ``there is some cause for concern...Despite recent hopeful news on the inflation front, the inflation outlook remains uncertain" and that "there is a significant possibility that inflation rates will remain above those consistent with price stability for some time." Plosser addressed the need to be vigilant and act when necessary, ``So we need to remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy's long run performance...if unacceptably high rates of inflation persist or public confidence in long-run price stability seems to diminish, additional monetary policy tightening may be necessary."

Fed Chief Ben Bernanke, while acknowledging the substantial weakness in the housing sector was in a quandary on the degree or extent of the probable fallout, ``It is a little difficult how the dynamics are going to play out”, although he waxed optimistic, "At the same time, I think there are some strong fundamental underpinnings that should help the housing market over the medium term, he said. These include: a good job market, strong income growth, demographics and continued low mortgage rates... To this point, other parts of the economy are remaining relatively strong”.

What these Fed officials have been trying to say has been antithetical to the expectations of the market. In other words, the financial markets have been at odds with the Fed!

I’d like to add that the recent speech by Fed Chief Ben Bernanke at the Washington Economic club highlighted the structural imbalances seen with the government’s welfare or entitlement programs, particularly the Medicare and the Social Security System. He notes,

``The fiscal consequences of these trends are large and unavoidable. As the population ages, the nation will have to choose among higher taxes, less non-entitlement spending, a reduction in outlays for entitlement programs, a sharply higher budget deficit, or some combination thereof...

``Assuming it unfolds as expected, the projected aging of the population implies a decline over time in the share of the overall population that is of working age and thus, presumably, in the share of the population that is employed. For any given level of output per worker that might be attained at some future date, this decline in the share of people working implies that the level of output per person must be lower than it otherwise would have been. In a sense, each worker’s output will have to be shared among more people. Thus, all else being the same, the expected decline in labor force participation will reduce per capita real GDP and thus per capita consumption relative to what they would have been without population aging.”

These are hardly bullish factors for US assets going forward as about 78 million baby boomers (birth years: 1946-1964) enter into the retirement age in the coming years.

Remember without adequate savings, you would find retirees selling assets to finance consumption. Further, the imbalances, as a result of present demographic trends, (assuming its continuity) would lead to a smaller ratio of workers subsidizing for each retiree, whose lifespan would have been prolonged by the unfolding technological breakthroughs in healthcare sector, would take its heavy toll relative to the nation’s fiscal position.

While of course, Bernanke and the Fed may use monetary tools to “raise the savings rate” of which he advocates as a principal solution to the present dilemma, perhaps in cognizance of the degree of leverage the country is exposed to, which makes the economy highly interest rate sensitive, he has instead tossed the problem to the legislative branch for resolution via his “recommended” reforms. Bernanke said, ``Reform of our unsustainable entitlement programs should also be a priority. The nature and timing of those reforms will be determined, of course, by our elected representatives.” It becomes a case of a “hot potato” where no one wants to own up to the festering problem.