Newspaper article St Louis Post-Dispatch (MO)

Complacent Markets May Be Caught Flat-Footed Again

Newspaper article St Louis Post-Dispatch (MO)

Complacent Markets May Be Caught Flat-Footed Again

Article excerpt

Last January, the financial markets were feeling very complacent. Interest rates had been falling for years, and few people believed there was any major trouble ahead.

Then the Federal Reserve abruptly started to raise interest rates. The complacency disappeared quickly.

Remember what I've been telling you. The hike in interest rates in January had little to do with inflationary price concerns and more to do with the Fed's notion - a correct notion - that the financial markets had created a bubble. The only inflation that the Fed was worried about was in asset prices.

Stock prices were too high because a lot of amateur investors had been sucked into the market. And bond prices had risen too much - and rates had fallen too far - because investors didn't think interest rates would ever come down again.

Back then I warned readers that the sharp rise in the fourth-quarter gross domestic product - which gained 7.0 percent mostly because of extreme weather conditions - would give the Fed the excuse it needed to raise interest rates.

The Fed did raise interest rates. In fact, the fourth-quarter GDP turned out to be the excuse that has allowed the Fed to raise rates four times.

It's now July, and the markets are complacent again.

But this time the markets are certain that interest rates will continue to rise because the markets are sure that the economy is doing well.

More to the point, the financial markets are so complacent that the Federal Reserve thinks the economy is doing well and will keep interest rates at current levels or higher.

The complacency could be misplaced again.

In the next few months, the nation's economy will continue to slow. The economy could be growing at a barely perceptible 2 percent or less by November. And if the Republicans make major gains in Congress that month, the pressure on the Fed to cut rates will be intense.

But the change in Fed policy shouldn't take until November. If the dollar starts to behave - and it wasn't as of this writing - there should be intense pressure on the Fed to keep interest rates at current levels. But the clamor could be for the Fed to cut rates.

Fed watchers already detect backpedaling. In recent weeks, Fed officials have been predicting that the economy would slow. These officials have been talking less about inflationary pressures.

The only talk about raising interest rates has come in reference to needing to protect the dollar, which has been declining in value against the Japanese yen.

And there is good reason for the Fed, and everyone else, to start noticing the slippage in the economy.

As it looks now, the nation's gross domestic product should be up between 2 percent and 2.5 percent on an annual basis in the second quarter. Translated, that means the economy grew just 0.5 percent between March and June, hardly enough growth to be noticed. …

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