All eyes and ears were on the two-day meeting of the Federal Reserve’s Open Market Committee (FOMC) that ended on March 21. While most observers did not expect interest rates to change — the FOMC has kept the federal funds rate steady at 5.25% for some time — the markets were keen to know what language the Fed would use about inflation in its statement on economic and monetary policy. The U.S. economy has seen mixed signals lately, with some signs pointing to slower growth while others indicate rising inflation. As a result, concerns about recession have been replaced by worries about “stagflation” — or stagnation combined with inflation. Is stagflation really looming, and if so, what will it mean for investors? To answer these questions, Knowledge at Wharton spoke with Jeremy Siegel, professor of finance at Wharton and author of the book, The Future for Investors.
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Knowledge at Wharton: What is your reaction to the statement released after the Fed’s Open Market Committee meeting today? The language dropped the reference to “tightening.” Is that a good sign?
Siegel: It is if you’re a stockholder. I call this statement “halfway to neutral.” I think that they did a very clever job. With the concerns in the housing market, and with recent evidence that GDP is going to be below 2% in this first quarter, there were a lot of forecasters and analysts that were calling on the Fed to drop its tightening bias, which indicates that if they were going to move, it was going to be to raise the rates.
What they did in this statement is drop [the idea] that the next change must be an increase. They say that future policy adjustments will depend on the evolution of the outlook and inflation, rather than further policy tightenings. So they now allow for a drop in the rate — but at the same time, not to go all the way in that direction. The sentence, right before it, says that “The committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.”
So there was obviously a group in the FOMC that said, “No, inflation is not good enough yet- -we have to maintain that as our primary focus.” There was another group that was saying, “But we have to allow for the fact that if things get very slow and soft, we may have to reduce the rate.” And what they really did is they sort of split it down the middle, keeping the predominate concern as inflation, but allowing the flexibility that a future rate change might be in the downward direction.
Knowledge at Wharton: And the market really responded, didn’t it?
Siegel: Oh yes, stock markets love when the Fed relaxes credit. Liquidity and low interest rates feed the stock market. Now, the bond market has reacted favorably. But bond owners have a concern, because to the extent that the Fed isn’t taking a super hard line against inflation, that is a concern of a bond holder. This is because he or she gets paid back in dollars many years hence, and if inflation isn’t tended to, those dollars are worth less.
So, in the long run I would expect the bond market to react more neutrally to this, even though the possibility of a decline of the Fed funds rate is in the near future. But, it’s much more favorable for stocks because stocks are not as concerned about a little more inflation. They want the increase in credit and the lowering of the rates.
Knowledge at Wharton: You wrote in your newsletter recently that “The problem bedeviling the market is the simultaneous appearance of a soft economy and troubling price pressures.” What has brought about this situation, and how serious is the threat of stagflation?
Siegel: Well stagflation, which is the simultaneous appearance of inflation and a soft economy, is a very troublesome development for the Central Bank. It’s kind of… both bad worlds, and unfortunately over the last four weeks, we’ve seen a downward movement of economic growth, but very stubborn inflationary pressures. That’s why the word “stagflation” has begun to “bubble up,” reminding us of what happened in the 1970s. Fortunately, we’re no where near as bad as it was then, when we had unemployment of 8% to 10% and inflation of double digits. We’re no way near that situation.
Knowledge at Wharton: If the U.S. economy does slide toward stagflation, what course would you advise Fed chairman Ben Bernanke to pursue? During the Carter administration, Paul Volcker, who headed the Fed at the time, had followed a disinflationary approach. Does that make sense today?
Siegel: Oh yes, the Fed has to take cognizance of both of these possibilities. This release of the FOMC does that. Now, all that being said, most economists say that when “push comes to shove, the Fed must move against inflation, before it moves to lower rates and stimulate the economy.” The only situation in which this would not be the case would be if there were a very severe financial crisis or a development like 9/11.
If the sub-prime problem were to spread to many other credits, the Fed would be obliged to lower rates. But facing higher inflation in a softer economy, the Fed must first move towards the inflation. Now some people will object to the Fed’s stance today by saying that they are abandoning that inflation fight. I don’t think so. They say that it’s still a primary concern and they still expect inflationary pressures to moderate. They say the primary risk is that our projection won’t come true. They certainly keep the door open, so that if inflation does not moderate, they will have to stay tight and perhaps even move tighter.
Knowledge at Wharton: You just referred to the sub-prime mortgage market. The meltdown seems to be continuing. Do you think that it’s likely to spread further, and how can that situation be fixed?
Siegel: Fortunately, we’re seeing a better tone in the sub-prime market. Accredited Lenderhas received some hedge fund money, I think $200 million. Fremont Financial has arranged for the sale of several billion dollars of its sub-prime loans. The developments over the last three or four days have been very good in that market. And, that is one reason why Monday and Tuesday, even before today, we had the biggest two-day increase in stock prices in seven months.
This is because that situation is now not looking quite as scary as it did last week. We don’t see it spreading. I always say that this is a market where “no news is good news.” If we don’t hear about dominoes, about bad credit, we have the feeling that it is not spreading. The fact that there have been two injections of liquidity both for Fremont Financial and Accredited Lender is very favorable. I did note that the Fed did not mention the sub-prime or the mortgage market, or the stock market decline in their release. But clearly, by changing to a more neutral stance, they obviously are taking cognizance of the potential impact of instability in that market for the economy.
Knowledge at Wharton: What will be the affect of these kinds of factors on Equities?
Siegel: This release is very, very good for equities. It means that the Fed is not going to be stubborn and if things do slide down, the Fed will act. Again, the stockholder is right now worried about a recession or a near recession. That’s what could make earnings growth even turn negative. By the Fed’s release today, it’s saying that as long as inflation does not worsen dramatically from where we are now, we are willing to move the rate down if economic growth slows dramatically.
It doesn’t have to go to a recession. My feeling is that if we get growth projections below 1% — current projections for this quarter are 1-2% — if we start moving into the 0-1% [range], I think that the Fed will act by lowering the rates. That is going to cushion the earnings impact on the market, and that statement is sort of cutting off a bad occurrence which is prompting buying in the equity markets.
Knowledge at Wharton: How will you see the impact on the dollar?
Siegel: Well, the dollar took a hit as expected. The dollar goes by the short-term interest rates. If there is fear that the Fed is going to lower those interest rates or not raise them in the future, that will cause traders in the foreign exchange market to sell, and they did sell. However, at least in the first hour or two, it’s not a precipitous decline in the dollar. If traders think that the situation in the U.S. won’t be as bad as they had thought, that will bring in support for the dollar and capital. That may even be more important than not having a little bit of a higher short-term interest rate.
Knowledge at Wharton: Are there any international risk factors that investors should be paying attention to?
Siegel: Well, there always are. My feeling is that this problem really originated in the U.S., not in China. Interestingly enough, the Chinese market is almost and maybe even now past its all-time high. This was really an internal sell-off in the U.S. precipitated by the trend followers and then, because of the globalization of our markets, spread virtually everywhere. Also, of course, there is the fear that if the U.S. really slows down, everyone is going to feel it, because exports are huge to the U.S. and other parts of the world. If the Fed now says that they will lower [rates] if growth gets slow enough, that’s good for the international markets as well as the domestic markets.
It is certainly a reason to keep a very good international diversification in your portfolio. Again, there are always risks. Right now, gasoline prices are continuing to rise; I’d like to see a little bit of a slowdown there. We all are cognizant of potential problems in the Middle East. They’ve been there for many, many years. But the major problem, a meltdown in the U.S. and a very precipitous decline in economic activity, has now been lessened not only by what we see in the market but also by the Fed’s statement.
Knowledge at Wharton: On a day that’s been fairly good for investors, what advice would you have for people and their portfolios, going forward?
Siegel: Well, I said just a week ago or so that you should remain brave and be in the equity market. If we end up today at the gains that we saw in the first half hour, this will be the best three days in quite a while. I think that we could look for more gains through the end of the year. I’m still bullish on the stock market.