If This Fed Governor is Right, Then We're Headed for Trouble

David Sterman
Posted: Jun 20, 2012 12:01 AM

The Federal Reserve is gearing up for its once-every-six-week policy move on Wednesday afternoon, June 20. All eyes will be on Fed Chairman Ben Bernanke. Investors are increasingly expecting the Fed to provide more juice to the economy, either at this meeting or the next one. 

And if history is any guide, then that could give the market a short-term lift.

Any resulting rally, thanks to Bernanke and his board of Fed governors, isn't something you should be applauding. At least that's the view of Narayana Kocherlakota. He's the president of the Federal Reserve Bank of Minneapolis, and he's been steadily expressing deep concerns about Fed policy, even as most of the Fed's other regional heads have largely moved in lock-step with Bernanke.

If Kocherlakota is right, and further Fed action will do more harm than good, then your portfolio may be carrying too much risk. 

Uncharted territory
Though he has been vilified by both inflation hawks and inflation doves, Ben Bernanke deserves a huge dose of credit. Faced with a weak economy and an intransigent Congress, he has sought to help stabilize markets while pulling off a series of moves that might jumpstart growth. 

Though economic growth is still quite weak, it could have been a lot worse. A glimpse across the Atlantic Ocean gives a sense of just how bad things might have been. 

Meanwhile, concerns that Bernanke's efforts to stimulate the economy would lead to ruinous inflation simply have not come to pass. The Fed has been pumping money into the system, and its balance sheet -- a broad gauge of its lending to the financial system -- now stands at an eye-popping $2.87 trillion. 

That's a 200% jump since 2008. Yet key inflation measures still look quite benign. In the 12 months ending in May, wholesale prices (as measured by the Producer Price Index) gained just 0.7%. 

That's the lowest rate in three years.

So why is Fed Governor Kocherlakota so nervous? Because he says the Fed is pushing its luck and that the recent spate of aggressive moves will eventually backfire. While Bernanke is looking for ways to further boost the economy (with rumors of another round of Quantitative Easing possible in this week's meeting or in the next one that takes place in early August), Kocherlakota says the Fed needs to start focusing on the risks of further intervention.

To be sure, rates likely won't be hiked until early 2015. But Kocherlakota says rates should start rising by the end of this year or in early 2013. He doesn't want to wait for the economy to move onto solid footing before rates move up off of their historic lows. Kocherlakota knows that once inflation starts to creep into the economy, it feeds on itself, as a wide range of industries start raising prices to offset their own rising costs.

He's not alone. Philadelphia Fed Governor Charles Plosser and Dallas Fed Governor Richard Fisher believe "the longer the Fed's balance sheet remains bloated with record-high reserves, the greater the upside risks to inflation," note economists at Merrill Lynch.

Years of under-investment
These inflation hawks may be taking note of the fact that companies have sharply under-invested in manufacturing capacity during the past four years. They are learning how to squeeze every drop out of current capacity, but may soon run up against natural limits.

A few years ago, capacity investments made little sense. In the spring of 2009, just 66.8% of our nation's manufacturing capacity was being utilized. By last spring, that figure rose to 76.3%. Yet in the past two months, the nation's Capacity Utilization index  has moved above 79%. As long as the economy keeps growing (at an even modest pace), that figure will keep rising, assuming companies don't start building new factories.

And that spells trouble. 

Whenever the Capacity Utilization index moves into the low 80s, inflation pressures have historically begun to emerge. That's because bottlenecks start to kick in, so companies start to have more pricing power as customers scramble to get their hands on goods in a timely manner. The fact that we're approaching the low 80s with a very weak economy tells you just how unprepared we are for a hike in economic activity.

Risks to Consider: As an upside risk, the economy could handle a modest increase in inflation and interest rates without running the party for stocks. 

Action to Take --> This summer's economic data needs to be closely watched. If the economy shows further signs of weakness, then analysts could lower their earnings forecasts and stocks could see another wave of selling. But if the economy doesn't flounder and shows signs of resilience in the second half of 2011, then the Fed's $2.87 trillion gambit could raise its own set of concerns. That's why Kocherlakota warned at the May FOMC meeting that the Fed "should be thinking about initiating our exit strategy" in six to nine months' time.

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.