This week we had two more Federal Reserve members repeat what has become the theme for their chorus, but not one the market seems to be paying much attention to. It should be. The market believes the Fed will soon start to cut rates, perhaps as early as first quarter of next year. It is not altogether clear that this will be the case.

I must admit to being somewhat baffled as to the apparent disregard by the stock market for what I view as a tough environment in the medium term with either a slowdown or a mild recession being suggested by numerous factors. While there are a lot of positive features to the economy, to me the risk to the economy still seems to be to the downside. I take small comfort in the fact that this perspective is shared by Fed Vice Chairman Donald Kohn, a very solid economist and financial market observer.

On Tuesday night at New York University, Kohn stated that he is more concerned about inflation than slowing economic growth because a recession is unlikely. "In the current circumstances, the upside risks to inflation are of greater concern...I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point."

The Need to Raise Rates

Rumor has it that Kohn was Greenspan's preferred choice to follow him. In any event, he is closely tied to Bernanke. I think it is highly likely that Bernanke shares those sentiments. But they are not nearly as hawkish as the speech on Thursday by new Philadelphia Federal Reserve President Charles Plosser. In a speech peppered with stern anti-inflation warnings, and echoing the sentiments expressed by Dallas Fed President Fisher (which we discussed at length about a few weeks ago), Plosser said the U.S. central bank's very credibility was at stake when it came to keeping prices under control.

"There remains some risk that policy is not yet firm enough to ensure a return to price stability over a reasonable time horizon...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," he said.

He was clearly concerned that inflation is above 2% and could stay above that level for some time. You cannot read that speech and find someone who is prepared to cut rates while inflation is still above 2%. He clearly said we may need to raise rates rather than lower them. He noted that the main job at the Fed is to maintain price stability. He will become a voting member of the Open Market Committee next year.

Quick aside: Ben Bernanke spoke this week, as well as Cleveland Fed President Sandra Pianalto. In addition to the previous two Fed members, they all acknowledged that the slowing housing market is a concern, but that the rest of the economy seems to be doing fine. Count them (at least publicly) in the slowdown and no recession camp.

But with few exceptions (actually one that I am aware of), Fed officials have been repeatedly saying since they paused in the rate-cutting process in August that they are concerned about inflation. They hope that a slowing economy will bring inflation back into their comfort zone of 1-2%.

But inflation has been rising. Let's go back to a chart we used last week, because it is important to remind ourselves that even though the Fed has paused, inflation has not. That is why Plosser, a very well-respected academic, suggests that the Fed may have to raise rates rather than lower them.

The chart looks at three ways to measure inflation, using the Fed's preferred Personal Consumption Expenditures (PCE) and the new Dallas Fed trimmed mean inflation. Inflation on a six-month and a 12-month basis has been trending up for the last six months in all three series. The one-month numbers, while more volatile, are well above the 2% comfort threshold. Let's look at the tables:

The Inflation of Expectations

Now, let's turn to good friend Paul McCulley's last posting. These comments were written after he was at the Fed Jackson Hole conference. If you can, I suggest you read the whole thing, but I will highlight some of the argument. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2006/FF+September+2006.htm

He is writing about why it is important for central bankers everywhere, and the Fed in particular, to maintain credibility as an effective inflation-fighting force. It takes the form of a discussion with his rabbit, Morgan Le Fay. (I've taken the liberty of some editing to help the context.) We jump into the middle of his discussion on the Fed and inflation expectations:

"...In the first instance, producers, consumers and workers negotiate about prices and wages in the context of what they see in the real world, based upon competitive forces.

"For example, there are three places within five minutes of here where I can buy your favorite romaine lettuce, along with groceries for me and Jonnie. I know that and the three stores know that, owners and workers alike. We are all grown-ups and know that the invisible hand will direct us the right way: I will shop where I get the most value for my buck, and the owners and workers will make the most where they provide the most value for my buck.

"Owners can't set their prices independent of the competition and workers in those stores can't demand wages that are inconsistent with the owners making money. Competition rules!

"However, according to the inflation expectations argument, we all know just how much inflation the Fed will or won't tolerate, which becomes the backdrop for our competitive game. For example, if I know, or at least I think I know, the Fed won't tolerate anything north of 2% inflation, then I will balk at paying anything more than that, sitting on my hands until one of the grocers recognizes my understanding of reality and sets his prices accordingly, perhaps encouraged by his workers who fear for their jobs.

"To be sure, this would mean that you would have to go without your romaine for a few days, which I would never let happen. But let's not let reality interfere with a good theory!

"And actually, it is a good theory: expectations of inflation - conditioned by expectations of just how much inflation the Fed will or will not tolerate before jacking interest rates, so as to throw some people out of work - do matter.

"Thus, the Fed's anti-inflation credibility does matter in the inflation process, not just the literal supply/demand conditions in the market for goods and services. This is particularly the case when the economy is hit by an adverse shock to inflation, such as a surge in oil prices.

"By definition, such a shock will lift actual printed inflation, as the case has been over the last two years. But if the Fed has high anti-inflation credibility, producers, workers and consumers will not extrapolate higher printed inflation as a sign of what inflation will be over the long-run, but rather treat the oil shock as a one-off hit to the level of real incomes, which simply must be tolerated.

"This wasn't the case in the nasty 1970s of my youth, of course, when higher printed inflation borne of oil price shocks led producers, workers and consumers to anticipate permanently higher inflation, which became a self-fulfilling prophecy, until the Fed, led by Chairman Paul Volcker, induced a blood-curdling recession.

"Thus, there is good reason for policymakers to want to preserve their anti-inflation credibility: it increases the odds that one-off price shocks remain one-off price shocks, rather than a self-feeding, accelerating inflationary process. The reason this stuff is hard to explain is because it's actually the toughest analytic problem in modern macroeconomics: how much do inflation expectations matter in the wage and price setting processes, and how much should they influence central bank behavior?

"Both at and away from Jackson Hole, people who do what I do for a living all agree that expectations matter, but there is no clear consensus on just how much they matter or just how much the Fed should try to flat-line those expectations. I'm on what is called the "dovish" end of the spectrum in this debate.

"...in the central bank game, doves are people who believe that the Fed should think long and hard about throwing people out of work, while hawks are people who believe the Fed should think long and hard about not throwing people out of work, if and when it appears that inflation, or worse yet, inflationary expectations, rise above some self-proclaimed "comfort zone." Neither the doves nor the hawks can claim to be unambiguously right, because there is an element of truth to the propositions of both camps. In the end, it's not just an empirical matter, but a matter of value judgments, mixed with differing degrees of faith in understanding how the economy works. Which is what makes an event like Jackson Hole so interesting!"

(Again, my invitation to Jackson Hole got lost in the mail. There are few economic events I would really like to attend, but this is one of them. Maybe some day.)

The Fed has a very interesting problem. They acknowledge the economy is slowing, but at least publicly think the slowdown will be mild. If that is the case, then it may not bring inflation down below 2%, or even close. If that is the case, do they raise rates at some point next year as Plosser suggested, not just to maintain their credibility but to stave off inflation expectations?

A Slowing Labor Market

Central to their problem is the employment rate and consumer spending. Housing is definitely slowing down. At the height of the housing market, consumers (on a national basis) were borrowing almost 10% of their income as mortgage equity withdrawals. This cash-out refinancing added over 1% and maybe as much as 1.5% to GDP. Such re-financing has dropped to under 6% and looks like it is in freefall on the charts. Bernanke said in his speech that a slowing housing market could shave 1% off of GDP. GDP last quarter was 2.6%. Between housing and lower consumer spending due to less borrowing, it doesn't take a lot to get that down to the 1% range.

There is a close correlation between housing prices and consumer confidence, and thus consumer spending. Consumer spending does not have to contract, it just has to slow down for it to have economic repercussions when home building is going to slow down over at least the next two quarters.

Today we saw the new jobs data come in quite weak at a mere 51,000 jobs. But past months were revised significantly upward, giving decidedly mixed signals. August was up 60,000, giving an average of 121,000 for the third quarter versus 115,000 in the second quarter and 176,000 in the first quarter. While the market saw the report as stronger because of the revisions, employment is a lagging indicator.

There was a giant revision of 810,000 to the March 2006 benchmark employment levels. Without going into details we have covered in past letters, there is a second set of government employment numbers called the household survey numbers. With the revisions, that meant employment rose by an astounding 438,000 last month. The survey numbers now show a difference of 1.7 million employees from the payroll numbers. Which one is right? All these revisions merely suggest that you cannot rely on one set of monthly numbers. And that we may not be very good at measuring employment.

But the leading employment indicators are not all that good, as highlighted by The Liscio Report from this Thursday (They do an excellent analysis of employment and tax receipts, among other things. Very solid reading, but I do not have a web site address for them. If I get one, I will put it in a later letter.) Let's look at what retail employment may be telling us. Quoting:

"We've noticed that retail sales has a tendency to lead broad employment trends by a few months. As the chart below shows, the pace of yearly retail job growth has fallen sharply, and is now negative. A model we've built using the gap between total and retail employment growth to predict changes in the rate of total job growth three to six months out suggests that monthly payroll gains should trend towards 100,000 by yearend, and possibly below in early 2007.

"If this is true- and it's underscored by the performance of our leading index of employment - the unemployment rate will have to rise. The growth rate in the civilian population has averaged 229,000 a month over the last year. To keep the employment/population ratio constant would require 144,000 new jobs a month (roughly, since we're not adjusting for demographic changes, and for the disharmonies between the household and establishment surveys). If job growth falls to around 100,000 a month, the unemployment rate will rise to over 5% by the fall of 2007.

"As we've often argued, based on the numbers and our reading of FOMC transcripts, the Fed pays more attention to the unemployment rate than the markets allow for, which would suggest easing would begin sometime next year. Of course, if lower oil prices stimulate growth, then the outlook could change. It could also change if animal spirits are rekindled rekindled in the housing market. But despite what Michael Moskow [Chicago Fed President] says, a labor market weakening to 100,000 new jobs a month-half the long term average, and about a third the rate normally seen in expansions- would be worrisome."

As a side note, The Liscio Report also notes that sales tax receipts "look punk," suggesting the economy is indeed slowing. This is in contrast to federal tax receipts and most states with income taxes seeing income rise dramatically, although much of the rate of tax increase is coming from those in the upper income brackets, and from increased dividend taxes receipts, in spite of the Bush tax cuts. Who would have thought? Tax cuts mean higher tax collections!

So why do we care about all the Fed speeches mentioned at the top of the letter? Because they are telling us that they will not cut rates if inflation does not come back into their comfort zone, EVEN IF UNEMPLOYMENT RISES.

Those market participants looking for the Fed to come to the rescue in January or March are likely to be disappointed. Unless inflation slows more and faster than it looks like it will today, the Fed is on hold for some time, even as unemployment looks set to rise. Interestingly, because of the upward revisions, the unemployment rate dropped to 4.6%, the lowest rate.

This just doesn't have the feel of Goldilocks to me.

Bernanke Has It Right

Bernanke spoke to the Economics Club of Washington. There was no mention of helicopters, but he used the stage to highlight what is the #1 economic problem facing this country, which both parties are ignoring in the political season. Much easier to focus on sex scandals than on the real scandal that is a true threat to our economic well-being.

What scandal? The willingness of Congress to ignore the coming crisis in Social Security and Medicare funding. "Reform of our unsustainable entitlement programs" should be a priority. "The imperative to undertake reform earlier rather than later is great." Let's look at a few quotes (you can read the very clear speech at http://www.federalreserve.gov/boarddocs/speeches/2006/20061004/default.htm):

"...the coming demographic transition will have a major impact on the federal budget, beginning not so very far in the future and continuing for many decades. Although demographic change will affect many aspects of the government's budget, the most dramatic effects will be seen in the Social Security and Medicare programs, which provide income support and medical care for retirees and which have until now been funded largely on a pay-as-you-go basis. Under current law, spending on these two programs alone will increase from about 7 percent of the U.S. gross domestic product (GDP) today to almost 13 percent of GDP by 2030 and to more than 15 percent of the nation's output by 2050. The outlook for Medicare is particularly sobering because it reflects not only an increasing number of retirees but also the expectation that Medicare expenditures per beneficiary will continue to rise faster than per capita GDP. For example, the Medicare trustees' intermediate projections have Medicare spending growing from about 3 percent of GDP today to about 9 percent in 2050 -- a larger share of national output than is currently devoted to Social Security and Medicare together.

"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. To get a sense of the magnitudes involved, suppose that we tried to finance projected entitlement spending entirely by revenue increases. In that case, the taxes collected by the federal government would have to rise from about 18 percent of GDP today to about 24 percent of GDP in 2030, an increase of one-third in the tax burden over the next twenty-five years, with more increases to follow. (This calculation ignores the possible effects of higher tax rates on economic activity, an issue to which I will return later.) Alternatively, financing the projected increase in entitlement spending entirely by reducing outlays in other areas would require that spending for programs other than Medicare and Social Security be cut by about half, relative to GDP, from its current value of 12 percent of GDP today to about 6 percent of GDP by 2030. In today's terms, this action would be equivalent to a budget cut of approximately $700 billion in non-entitlement spending."

Bernanke goes on to say that current policy and the savings rate means that future generations will have 14% less potential for consumption than would have been the case if there were no demographic issues with Social Security and Medicare.

There was a lot more to this speech, and it should be required reading for every member of Congress. It would be nice if voters actually understood. Yet, I heard nothing about it on the news. It was all sex scandal and the Republicans imploding. So much for serious policy debate.

It is highly unlikely that anything will get done in the last two years of Bush's presidency. He gamely tried and couldn't even get his own party to the table. Think it will happen in the first term of the next president? That means at best it will be 2014 before anything gets done, and the situation will be a lot worse. But good on Bernanke for high-lighting the problem.

The NBA and Ahead of My Time

I had more than a few friends, not to mention my kids, point out to me that my birthday was not last Tuesday but on Wednesday. Oh, well. Just goes to show I am a man ahead of my time, at least by one day. But I did do 57 push-ups and dropped another pound or so. Maybe by this time next year I will be at my goal. Next weekend all the kids come home to celebrate my birthday along with #2 son, whose birthday is later in October. I am looking forward to it.

And speaking of next week, it is already time for the NBA to start. While I have an office in the Ballpark and get to see the Texas Rangers from my balcony, my real love is professional basketball. I have been lucky and in the last few years worked my way down to the front row from the very top row in the corner more than 20 years ago.

Last year the Dallas Mavericks broke my heart at the last game, but it is another season. Even in the bad years (and the Mavs before Mark Cuban had gotten really bad), watching NBA level basketball is a pleasure. It is the most beautiful of sports, athletic poetry, choreographed as smoothly as a ballet, but all above the rim. These guys can do things that the rest of us mere mortals can only dream about. If you are ever at the games, drop me a note and I will try and meet you at the Platinum Club.

It is time to hit the send button. Friends are waiting and I am getting hungry. Have a great week.

Your can't wait to see Dirk play again analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

• Ben Bernanke
• Employment
• Inflation
• Interest Rate
• The Fed

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