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Easy Al's 1% Wonder

Troubling Consequences

If 1% fed funds rates and 5% mortgages are "normal" in an environment of 6% nominal GDP growth, exploding commodity prices, strong real estate conditions and soaring equity markets, then things will be fine. If 1.6 million personal bankruptcies and up-to-the-edge consumption are sustainable, then I should call my banker to borrow a few million! If the concept of job/income growth supporting real, unlevered economic growth is obsolete in a finance-based economy, the day of reckoning need never appear. If there is no practical limit to the total debt-to-GDP ratio (yes, I know it compares a stock to a flow, but so does a price-to-earnings ratio!), then my concerns are for naught.

But if things are not very, very different this time, an adjustment to more normal savings, consumption and balance-sheet ratios could prove awfully painful. If the financial markets ever adjusted nominal interest rates for the current 3% to 4% true inflation rate, then watch out below.

Right now, investors are enamored with depressed interest rates and the Fed's ability to remain accommodative (I'd suggest promiscuous) for quite some time. Based on these factors, some market commentators contend that valuations should be significantly higher, overestimating the ability of today's conditions to endure.

My sense is that most investors perceive normal rates to be 100 or 200 basis points higher, so when Greenspan loses his "Easy" adjective, short rates will rise to 3%. But Greenspan himself recently noted the fact that the fed funds rate has historically matched the nominal growth rates of the economy. That relationship suggests short rates closer to 4% or 5% and bond rates around 6%. Both the economy and the stock market would have extreme difficulty adjusting to those levels.

If Easy Al ever summoned the courage to re-establish the historical relationship between the fed funds rate and nominal GDP growth rate, then all bets are off. His current 1% Wonder would rapidly develop into the 5% Fiasco!
Robert Marcin is the founder and general partner of Defiance Asset Management. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). At the time of publication, Marcin had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to
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