$tarrBuck Report, June 18, 2006

                                June 18, 2006

The $tarrBuck Report

by R. M. Starr

Fear of the Fed

    Six weeks ago, the world’s stock markets were giddy with joy:  the Fed was surely done tightening interest rates.  For the next five weeks they declined in despair with the fear that inflation was on the way and higher interest rates must follow. 
    There’s just enough inflation in the core price measures (those that do not include the volatile food and energy sectors) for the Fed to stay alert.  The Federal Open Market Committee will probably to raise the Federal Funds interest rate target by an additional quarter of a percentage point at its late June meeting — just to show that its paying attention.  But interest rates are already in the Fed’s target zone, now a couple of percentage points above core inflation rates.  Further, barring further oil price increases, the impetus for acceleration in inflation is missing.  Interest rates are already where they need to be to restrain inflation.  The economy is still slowing in responce to the tightening of interest rates over the last two years.  The real estate market and economic growth generally are slowing down.  That’s plenty of restraint on inflation. 
    Best guess on monetary policy:  one more Federal Funds rate increase in late June and that’s it for the rest of the year.  Stock markets will recognize this as good news (either with the announcement accompanying the June meeting or after inaction at the August meeting)  and resume alternating between greed and fear. 

A decade long view of interest rates

    Structurally, throughout the world’s leading economies (US, Japan, Europe) the demographic bomb is ticking.  Aging populations mean that savings rates (already low in the US) will decline raising interest rates.  In the US, the Social Security surplus (that the Federal government has been freely spending) will shrink over the decade and become a deficit in 2017.  This means increasing government debt finance of all expenses including pensions and reduced private saving.  Bottom line:  expect increasing interest rates over the decade and beyond.  It’s not clear how this will parse between increasing real (net of inflation) interest rates and inflation. 
    Investment strategy:  avoid long-term nominal debt.  Fixed rate long bonds will decline in value as interest rates go up, since they have to compete with rising market interest rates.  Savings bonds are OK, since they can be cashed in at fixed values any time.  TIPS (Treasury inflation-protected bonds) are pretty good, since they include inflation protection.  Safest bet and a good return:  Six-month Treasury bills.  Buy them at subscription and roll them over.  Their yields move with the market and are California tax-exempt. 


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