We interrupt our regularly scheduled obsession with this afternoon’s Fed announcement with an observation about the supply of dollars as it relates to the ongoing elevation in the price of money. To cut to the chase, we can’t help but wonder if there’s a weasel in the monetary henhouse. Hey, we’ve got to do something as we wait for the non-surprise that comes later today.
What are we talking about? Just this: the rate of increase in M2 money supply has shown a tendency to ascend this year compared to 2005. There’s nothing especially intriguing about that, unless you consider that the central bank has been raising interest rates continually over that stretch. Ergo, what’s wrong with this picture? Namely, a rising Fed funds without a corresponding decrease in money supply.
Indeed, the rolling 52-week change is M2 has moved higher this year relative to where it was for much of last year. The latest reading (which will be updated this afternoon, as it is every Thursday) shows M2 advancing by 4.7% over the level 52 weeks previous. That’s nothing new by 2006 standards, which has shown M2’s 52-week changes sticking mainly to increases in the 4.5%-5.0% range.
The plot thickens, however, if you compare this year’s range to last year’s. In particular, from May 2005 to the end of the year, the span of M2’s rolling 52-week changes generally remained within the boundaries of 3%-to-4% ascents.
Perhaps the mismatch between this year and last is merely a technical hiccup, with no larger significance other than showing the machinations that accompany the business of manipulating, er, managing the money supply in the world’s largest economy.
Then again, maybe not. We say “maybe not” in light of the large and growing pressures that rest on the American government to spend more than it takes in over time. Deficits, in other words, lurk within the financial system, driven by such budgetary perennials as Medicare and Social Security.
Yes, the jury’s still out on how and when the associated deficits manifest themselves in altered fiscal and monetary policies than prudence otherwise dictates. Meanwhile, it helps to believe something’s askew if you’ve got a touch of the conspiracy theorist in you. (For those needing some help on this front, a quick reading of The Da Vinci Code might help stir those juices, even if the fiction in this case overwhelms the factual. But we digress.)
In the meantime, the Fed will keep changing the price of money while adjusting its supply. Over time, the two are intimately connected. In the short term, the connection can be tenuous and even contradictory. Such is the nature of reading long-term trends from short-term observations. Of course, occasionally the short-term contradictions offer early clues about changes in long-term policy. Deciding what prevails at the moment amounts to the art of observation. This, then, dear readers, is the golden age of observation in Fed matters.
With that, we now return you to our regularly scheduled Fed-watching program….

Tuesday’s update on existing home sales confirmed what Monday’s new home sales only hinted at: the real estate market’s cooling.
May’s tally of existing home sales (by far the larger data sample compared with new homes) dropped 1.2%, the National Association of Realtors reported yesterday. That’s the second monthly decline in a row, while May’s sales are off 6.6% from the year-earlier figure.
The Northeast U.S., the leading property market in the country, suffered the biggest hit in May, with sales of existing homes falling by 4.2%. Meanwhile, the West through last month endured the worst year-over-year comparisons, posting a -13.5% stumble in sales as of May.
This, dear readers, is what a cooling housing market looks like. And given the outlook for interest rates, which is still up, expect more of the same from the world of housing.
Additional clues of a slowdown in the formerly red-hot property market can be found in the stocks of home builders. Indeed, among the 129 equity industries tracked by Morningstar, home building is dead last in performance terms so far this year through yesterday, posting a -28.5% collapse. By comparison, the S&P 500 is up fractionally so far this year with a 17-basis point return through last night.

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Yesterday’s latest release of new home sales renewed talk that the much-discussed slowdown in housing has been greatly exaggerated. Don’t believe it. A cooling of the property market is unfolding. What’s debatable is the type and degree of aftershocks that will accompany the slowdown. On that, at least, there’s reason to pare one’s fears, if only slightly.
Yes, the May data for new sales of single-family homes for last month posted an unexpected pop, the U.S. Census Bureau reported yesterday. What’s more, the gain in May not only exceeded the consensus forecast; it was also the third straight month of higher sales, as the chart below illustrates.
But lest one thinks it’s time to rethink the notion that the real estate market is defying gravity, consider the broader perspective.
For starters, the number of homes sold dropped by 5.8% to 1.23 million, as of last month relative to a year earlier. Over the same period, the number of houses for sale jumped by nearly 24% to 556,000. More houses for sale and fewer sales. You don’t have to be an expert in property management to take the hint of what’s coming.
What’s behind the rise in the supply of houses for sale while the number of homes sold has dropped? Perhaps it’s the fact that mortgage rates are rising, making it more financially burdensome to buy homes. The standard 30-year fixed-rate mortgage was 6.83% last week–the highest in more than four years, according to a survey by Bankrate.com. The Fed seems inclined to keep that rate moving higher, insuring that the relative allure of real estate will wane further.

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The Federal Reserve weighs in again this week on the price of money. Functionally, nothing’s changed. It’s just one more summit on engineering an interest rate that a select group of Fed officials see as optimal. But measured by the context of the current global economy, the stakes in this week’s decision on the Fed funds rate are higher than before. In fact, that progression of an ascending ante promises (threatens?) to hold fast for the foreseeable future FOMC confabs.
For the one that arrives on this Wednesday and Thursday, the pressing question turns on where to err? On one side is the preference for nipping inflation’s momentum of late by elevating interest rates yet again, and thereby risking an economic slowdown of greater magnitude than would otherwise unfold. The alternative (which still appears out of favor but nonetheless within the realm of possibility) favors growth by keeping Fed funds at the current 5.0%. In theory, a third choice beckons: cutting rates, but almost no one believes this one’s a viable choice at the moment.
Deciding where the path of greatest prudence (or minimal recklessness) lies rests largely on how one sees or ignores the risks that lurk in the global economy. The Bank for International Settlements (the so-called central bank for central banks) last week handicapped the future on this score by opining that “the best bet for next year is that strong, non-inflationary growth will continue,” according to the new annual report for BIS. If so, the Fed’s job will be infinitely easier by widening the margin for error considerably in matters of monetary policy.
But even an optimistic take on what comes next shouldn’t ignore what might go wrong, and the new BIS publication lays out the range of possibilities with clarity. Summarizing the yin and yang of outcomes that may arrive in global economics boils down to the BIS advisory “there are considerable uncertainties and associated risks, not least concerning inflationary pressures on the one hand, and a possible unwinding of accumulated economic and financial imbalances on the other.”

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The economy of the United States is the wonder of the world. Growth is a perennial favorite, banishing all who expect anything less to the margins of pessimism’s dungeons. Ours, dear readers, is an era of economic resilience. The reason, as always, is that our hero, Joe Sixpack, is willing to spend till he’s red in the face (and on his balance sheet). Representing some 70% of the nation’s GDP, Joe and his counterparts are collectively the engine that defines and drives American economic muscle.
Joe’s inclination to keep spending these days, in turn, is powered by an inclination to keep borrowing, which corporate America has seen fit to make progressively easier over time without regards to creed, color or credit quality. The Federal Reserve this month put a new number on the extent of Joe’s readiness to engage in the most popular of American financial transactions: spending someone else’s money. In the first quarter of this year, the growth of household nonfinancial debt jumped by 11.6%, on a seasonally adjusted annualized basis, according to the Fed’s Flow of Funds report. That’s near the fastest pace of recent years, and well above the 6%-to-10% range of increase that prevailed during the latter half of the 1990s, a stretch that was no stranger to robust economic growth.
The Federal Reserve conveniently breaks down Joe’s fondness for red ink into two main categories: home mortgage and consumer credit. As the chart below reveals, ’tis the home mortgage category that’s doing the heavy lifting in elevating household debt to levels that worries some but otherwise encourages others.

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The allure of emerging market stocks is rooted in the notion that higher risk begets higher reward. But what happens if the higher risk loses some altitude? Does that imply that prospective returns will follow?
Such questions are topical these days in the wake of news that the financial profile of emerging market economies has improved considerably in recent years, and is poised for more of the same going forward. But will fiscal progress pare the extraordinary returns that emerging markets have been known to deliver relative to developed markets?
One indicator of the improving financial health of emerging countries can be found in the narrowing interest-rate spread of debt issued by these markets relative to high-grade bonds from developed countries. At the end of this year’s first quarter, the risk premium in yield for emerging market bonds was roughly 100 basis points over AAA-rated debt, according to the IMF’s 2006 World Economic Outlook. That’s a fraction of the 1,000-basis-point spread that prevailed in 1999.
The decline in risk spread has been driven by more than rank speculation. The underlying economic trends in emerging markets has been generally positive in the 21st century, in some cases extraordinarily so. Private capital net inflows, for example, have risen sharply for emerging markets in recent years, more than doubling in 2005 to $254 billion from just three years earlier, according to IMF data.

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Among the countless economic variables that the Federal Reserve routinely parses for inspiration on what to do next in monetary policy, real estate’s numbers no doubt carry significant weight these days. The housing boom in recent years has delivered a more than a little zest to the economy, courtesy of the ample liquidity that the central bank has supplied in years past. As such, if there’s any chance that the Fed would cease and desist in its current round of interest-rate hikes, real estate trends are likely to deliver an early warning.
What, then, should we make of yesterday’s release of May’s housing starts, which posted a 5.0% rise over April’s numbers–the first month-over-month increase since January? Is the real estate boom resuming? Is the former slowdown that we’ve been hearing so much about over?
Not necessarily. As Asha Bangalore of Northern Trust observes in a research note to clients yesterday, “Two-thirds of the increase in [housing starts in] May was from new construction of multi-family units, which tend to show a larger degree of volatility compared with the starts of single-family units. The rebound in May is tentative, at best. News from the housing market is marked with stories of declining orders and lay offs.”
In fact, confidence among home builders has continued to drop precipitously this year, as tracked by the National Association of Home Builders/Wells Fargo Housing Market Index (HMI). The latest installment for June, released on Monday, maintained the trend: HMI dropped to its lowest level since 1995, NAHB reported. The cause? Rising mortgage rates, higher price hurdles for buyers, and the retreat of investors/speculators from the marketplace, according to NAHB’s press release. Adding to the gloom was the news that the fall in builder confidence was “broad-based and registered in every region this month.”

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If there’s such a thing as consistency in the capital markets in the 21st century, real estate investment trusts are the standard. Although the asset class has had its share of frights from time to time, REITs nonetheless managed to right themselves and post gains once the dust cleared.
The tendency to post returns in the black is again on display in 2006. So far this year, through last night’s close, REITs are up 9.30%, as per Vanguard REIT Index Fund. And as our chart below shows, REITs are also the leading asset class ranked by returns for the past month through yesterday. To find a calendar year in which REITs shed ground one has to go back to 1999, when the category retreated by 4.0%.

Asset class proxies: Vanguard REIT Index VIPER, iShares Russell 2000, iShares MSCI Emerging Markets, MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Short Gov’t Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities, PIMCO Commodity Real Return.
Such consistency is otherwise unavailable in the competing asset classes, at least when considered through the prism of recent performance. Foreign developed government bonds (based on the dollar-hedged PIMCO Foreign Bond Fund) appear to be a close second, as our chart shows. Indeed, this asset class also hasn’t had a down calendar year so far in this century. But where the category stumbles is absolute total return. PIMCO Foreign Bond posts a 5.24% annualized total return for the past three years through yesterday v. a sizzling 18.6% for Vanguard REIT Index Fund.

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There’s a school of thought in the investing world that believes in taking central bankers’ warnings at face value. Easier said than done. Fed commentary hasn’t exactly been surgically precise in the spring of 2006. The central bank has been inclined to suspend interest-rate hikes only to rethink such a halt, depending on who’s doing the talking.
But last week’s remarks from St. Louis Fed President William Poole seem to have put the matter to rest on what should come next regarding next week’s FOMC meeting and the related matter of the price of money. “If the inflation rate continues to be persistent like this,” he said last week, “the Federal Reserve will simply have to pursue persistent policies that will keep that inflation from increasing further.”
Poole was referring to last week’s release of May consumer prices, which, by any measure, are continuing to surprise on the high side. Consumer prices rose by an annual rate of 5.7% for the three months through May, the Labor Department reported last week. For those keeping score, that’s 70 basis points above the current Fed funds rate, a premium that amounts to an “ouch” for inflation hawks. Meanwhile, the so-called core rate of inflation (consumer prices less food and energy) advanced by 3.8% at an annual rate for March through May–the highest since 1995.
Taking it all in, there’s no longer reason to wonder if inflation is edging up–confirmation has arrived. The only question is how high is up? That depends on what the Fed does in coming months, starting with next week’s FOMC confab.
For perspective, keep in mind that some (if not most) of the uptick in inflation of late derives from the exceptionally loose monetary policy of previous years. Aggressively printing dollars for several years in the early years of this century is now coming back to haunt the system. Reversing the former liquidity boom will take time, probably years. Assuming, of course, the Fed has the stomach for the monetary fight that looms.
To be sure, no central bank exists in a vacuum. The willingness of the Fed to elevate the price of money for the world’s reserve currency may find some degree of support in central banks around the world. If the major overseers of currencies on the planet find reason to tighten, the Fed’s job will be that much easier, at least in a political sense.
Consider then last week’s economic news for Japan: first-quarter economic growth for world’s second-biggest economy was revised sharply higher to an annualized inflation-adjusted 3.1% from the previous 1.9% estimate, representing the fifth-consecutive quarter of growth in the Land of the Rising Sun. How high is 3.1%? Nearly twice as high as the 1.82% yield on a Japanese government 10-year bond. Rarely has the case for a rate hike in Japan been so clear and compelling.
The mind-set for similar action is taking hold of policy makers can be found in the U.S. as well, albeit in milder form. GDP’s rate of ascent for America in the first quarter was a sizzling 5.3% in the first three months of this year, or slightly above the 5.13% that currently defines the yield on a 10-year Treasury. Yes, a slowdown in economic growth is coming. But broad confirmation of that forecast won’t come until July 28. But the Fed doesn’t have the luxury of waiting that long.
Sitting on one’s monetary hands for more than a month, given the latest dispatch of inflation numbers, is the financial equivalent of fiddling while Rome burns. Fed Chairman Bernanke can’t afford a Nero complex at this juncture, and neither can the U.S. economy. In fact, sending a hawkish signal by way of a 50-basis-point hike next week might be just the thing to establish Bernanke’s credentials while the aura of economic growth still hangs in the air. Retreating later on would be easy, if GDP falters. By contrast, going soft now, and trying to catch the inflation train down the road only promises trouble by way of a diminished odds of success. Ergo, the June 28/29 FOMC may prove to be one of the more crucial meetings (for good or ill) in Bernanke’s tenure.

Yes, it’s true. We’re laying down our analysis, putting our pen to repose, and otherwise cooling our publishing heels. But just for a week. That, at least, is the plan as we decamp to warmer climes for a short break. But we’ll be returning on Monday, June 19, and dispensing more of the usual. Presumably, there’ll be a story or two waiting for us.