Wednesday, April 21, 2004

Everyone Calm Down

The market took a dive today on the assumption that interests rates will rise some time this year. While Fed Chairman Alan Greenspan did not say it directly, investors believe that the Fed will raise rates because of remarks Greenspan gave today on Capitol Hill.

The Dow was up 20 points before Greenspan's remarks and then dropped 40 points quickly after, ending the day down more than 120 by the market抯 close. Tomorrow will be even more telling for the markets when the Fed Chair will be before the Joint Economic Committee of Congress. If he hints that interest rates will be raised this year, you may see another sell off in the markets as you will see profit taking and a consolidation of peoples' positions for a higher interest rate environment.

But before we decry higher interest rates and fear this will doom our growing economy, we must look at some important market factors. First of all is that we have had exceptionally low rates for an exceptionally long period of time. This is what helped fuel that massive increases in home ownership and home refinancing that we have seen in the last two years. It is also what has made home prices skyrocket and has made people jittery that we will see the housing bubble burst. A growing economy will still increase demand on housing, but at a slower rate than we have seen.

Secondly, with an increase in the prime rate, we will have finally gotten rid of the specter of deflation (a massive dive in prices卾ery bad stuff). Not that this has been on anyone抯 mind over the last few months, but it was a concern and we were able to avoid it. An increase in the prime rate will also have an impact of foreign investment that is currently sitting in foreign markets that have higher rates of return.

Thirdly, as the labor market increases there will be an increase of disposable income being put into the market from these new workers?paychecks. This increase of money tends to drive up the cost of goods (increased competition for goods raises the price of goods). An increase of the prime rate will make it more expensive for people to borrow money from the banks (higher interest rates on loans) and therefore helps to minimize the impact of inflation.

The Fed under Greenspan has a history of believing that inflation is the pariah of the economic universe. Greenspan believes that dealing with inflationary measures is one of the surest ways to keep an economy healthy. So if he believes that there is an inflationary pressure upward on the market, he will not hesitate to raise rates, even in an election year (which is why the Fed is largely separate from the politics of Washington).

Unlike the money makers on the Street and the economic pundits on tv, I take a different view. I can抰 wait for the interest rates to rise. Why? Because knowing Greenspan, he is only going to raise rates when he absolutely must. And that will mean that our labor market is such that there is going to be inflationary pressures. A quickly growing labor market means more people are going to work, paying taxes, and have money to spend. An increase in rates will push off the chance that the housing market will burst. And in increase in rates will make America a more attractive place to invest.

Not 5 years ago we had a prime rate of over 7% and today it is only 1%. This market and the American economy can handle a small increase this year. It will probably happen this summer. It gives Greenspan more jobs numbers to base internal inflationary pressure on the market unrelated to commodity prices outside of our control (oil and metals). The market will price in the increase in rates so while there may be a temporary sell off in the markets, it won抰 have all that much of an effect.

End of the year prediction? Dow 11,400.

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