Seeking Alpha
Profile| Send Message|
( followers)
Yesterday morning, Uncle Ben provided a fairly upbeat commentary on the US economy and re-emphasized that inflation remained a risk. According to the pundits, the markets decided that means either little chance of a Fed Funds rate cut or an increasingly likelihood of higher interest rates; and, as we all know, stocks declined.

We don't think that this is the correct read. Like the last time the market had a bad day, we think, for a number of reasons, that Tuesday’s market action was more a function of investors taking a breather than signaling an increased probability of higher interest rates which might seriously challenge the current market uptrend.

Those reasons are:

(1) The Fed is tasked with two missions--controlling inflation and insuring a benevolent environment for economic growth. Seldom does a Fed representative make a public statement even in the best of times and not point to one of these two areas of concern; after all, they are getting paid the big bucks to worry, no matter how good conditions seem to be. In our opinion, that is all that happened yesterday. It doesn’t follow from anything Bernanke said that either the Fed won’t lower interest rates or that it will raise them.

(2) There simply isn’t yet enough evidence to know whether or not the positive economic data we got in April/May--and to which Bernanke referred yesterday--means the worst is behind us. While our working economic thesis right now is that the economy is recovering we have to acknowledge that there is not yet sufficient data to defend that position with great certainty. Hence, we think it too soon to be betting that not only is the economy improving but that also it is doing so in such a way to raise inflationary pressures sufficiently to either prevent the Fed from easing monetary policy or force it to contemplate an interest rate hike.

(3) Even assuming that the economy is improving that doesn’t mean that inflation is a risk or that the Fed will raise rates. Consider: [a] the rate of US economic growth is among the lowest in the industrialized world yet inflationary forces internationally are declining, [b] the latest US inflation data--both the forward and backward looking indicators--shows pressures moderating, [c] finally, growth and full employment are goods things and they don’t cause inflation; inflation is the result of too much money chasing too few goods.

(4) All this said, even if the Fed doesn’t tighten monetary policy, we need to point out that some increase in interest rates is still possible, IF the economy were to rebound so strongly that the demand for capital would raise the real price of money (i.e. the real rate of interest). But for that to happen, corporate earnings growth would likely be much higher than now forecasted--and the improving rate of profit increases would offset the impact that a modestly higher real interest rate would have on equity valuations [i.e. a lower price/earnings ratio].

Bottom line, we think that Tuesday’s market action was less related to the fear of higher interest rates and more to the need for a rest.

Source: Why Bernanke's Statement Doesn't Indicate Anything