Thursday, June 14, 2007

Credit Squeeze on the Horizon, With or Without the Fed

Looks like the infamous "conundrum" (former Federal Reserve chairman Alan Greenspan's way of describing seemingly counter-cyclical low market interest rates that stayed low in spite of the Board's supposed efforts to raise them) are now becoming a "reverse-conundrum." The Fed hasn't moved a muscle yet to raise rates further, but that hasn't prevented the interest rate market from increasing on its own.

Yes, rates are beginning to increase again, as you may know if you have an adjustable mortgage. At the same time, wholesale prices are on the rise, forecasting a lift in consumer prices down the line, which prediction I have confirmed anecdotally. My business friends have described to me in detail the doubling of the rent for commercial space in Los Angeles, the increasing financing costs, and the rising costs of raw materials and labor, all of which put pressure on them to increase their own prices.

On the other hand, they all have also told me that their turnover has dropped some three to five percent. This creates what economists like to call a "squeeze," or pressure from two sides. The squeezed entrepreneur should raise prices three to five percent to cover his increased costs, but he doesn't out of fear of of losing market share. And let me remind you that this squeeze comes right off the top, i.e. out of net profit.

cat-squeeze
[Thanks to darnet.ru for the photo.]

[NB: About my use of anecdotal information: For all you economic "scientists" out there (and you know who you are), let me remind you that this is my blog, and that therefore I can allow myself to be as informal and personal as I wish. Some blogs (like this one), are written mainly for entertainment; but common sense can still peek through, couched inside a little humor. Although I appreciate the rigors of the scientific method in more formal pieces, I enjoy the license afforded to me by this more flexible and entertaining medium, to get basic points across while having a little fun. Just because the intent is to entertain does not mean that the writer and readers cannot also be sharing something useful.]

Restaurants in Los Angeles are not the only business people feeling the squeeze. Wall Street financiers are, too. In this article by Yalman Onaran at Bloomberg, we read that Bear Stearns's profits are also down. They are suffering from another kind of squeeze, this time from the repressed subprime mortgage market and from rising interest rates. We also read here in an article by Kathleen M. Howley at Bloomberg that the number of late mortgage payments has reached a record high.

There is a third squeeze that will be forthcoming, I predict (unscientifically). The Federal Reserve will find that they are squeezed between two clauses of their own mandate. The first requires them to make every effort to control US inflation. To measure this, they read many statistics including the CPI, the Producer Price Index or PPI, various production figures, inventory figures, and lots of others. These are showing earnest signs of rising.

The second mandate on the other side of the Fed squeeze will be the clause pertaining to GDP and unemployment. The Fed also watches many figures pertaining to these two gauges. What happens if they start to read signs of inflation on one hand, and signs of stagnating GDP, and/or even rising unemployment, on the other? You guessed it: S-Q-U-E-E-Z-E. Or as the Fed would call it, stagflation.

What will they do? This is anyone's guess. I've had fun trying to imagine at this previous post and this one. The truth of the matter is that no matter what they do, there is a good chance it will be counterproductive--as usual--unless they can actually persuade themselves to do nothing. Historically, that would be rare.

Bear Stearns et al., well, they are juggling their portfolios to cover their behinds, and I guess if worse comes to worse, they can always ask their upper management to return all those bonuses to buck up the bottom line. (Good luck.)

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