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Friday, July 14, 2006

The Sacrifice Ratio

Interesting article by Casey Research Inc. on the so-called "Sacrifice Ratio" which the Fed supposedly weighs carefully. Basically it says the sacrifice ratio right now is so high, at "4", which explains why the Fed has chosen to hike interest rates bit by bit (17 straight 25bps hikes) instead of reigning in inflation at once. Which means more rate hikes. Basically an added reading to Freddy's post "The Bear Case". Very interesting... read on!

The Sacrifice Ratio

Whither interest rates?

That's the question everyone wants the answer to. Each time the Federal Open Market Committee (FOMC) has a scheduled meeting, economists and analysts tie themselves in knots trying to anticipate what will happen. Even between meetings, the process never lets up. Notes of the previous gathering are pored over, and every word uttered in a speech by a member of the Board of Governors is scrutinized for its hidden meaning.

No wonder. Interest rate decisions by the Fed have a profound short-term effect across the markets, from stocks to gold to the value of the dollar in international trading.

The factors that contribute to the decision-making process are many, but one of the most important is also the most arcane. Few have heard of it, even among relatively sophisticated investors; fewer still watch it closely.

It's a simple number called the sacrifice ratio.

If that sounds a bit ominous, that's because it is. It means that somebody or something is going to be sacrificed in order to achieve some other end. That's the way of the world in a "controlled" economy such as we have today.

Control of the economy has been one of the primary functions of the Federal Reserve since it was created in 1913. The truly free market was too unpredictable, too subject to wild swings, argued the founders (a group of the nation's leading bankers, acting primarily out of self-interest). The Fed was needed to smooth out the rough spots and to promote, in its own words, "objectives such as stable prices, high employment, and economic growth."

(Considering that, since the birth of the Fed, we've had one Great Depression, a number of recessions, the hyperinflation of the late '70s, and a 96% decline in the purchasing power of the dollar, some might be tempted to ask in what way it's been doing its job.)

The Fed pursues its goals by raising or lowering the prime interest rate--the rate it charges its most favored customers, and from which other lenders take their cue--and by deciding whether to increase or decrease the money supply. In general, lower interest rates and more dollars pumped into the system heat up the economy, causing a rise in both employment and inflation. Conversely, when interest rates rise and money tightens, the economy cools, unemployment goes up and inflation comes down.

That's where the sacrifice ratio comes into play.

The actual formula the Fed's math majors use in computing sacrifice ratio is extremely complicated. For our purposes, though, what we need to know is what it expresses. In greatly oversimplified terms, it is the amount of extra unemployment that will result from an interest rate hike, divided by the amount future inflation will be lowered by the same rate increase.

In other words, when you do this kind of economic tinkering, there's always a tradeoff. Are you willing to swap people's jobs for a curb on the cost of goods and services? At what point, and to what extent? This is the Fed's perpetual dilemma, where to make that trade.

Worse still, the Board has to make its decision based on what it thinks the situation is going to be in the future. It has to look out a year or more and, for example, mount a fight against inflation that hasn't yet happened.

The sacrifice ratio (SR) is a small, single-digit number. Think of it as the percentage rise in unemployment that will result in one year from a corresponding fall in inflation. Thus, if SR=1, a one percent drop in inflation over the coming year will theoretically produce a one percent bump in unemployment.

SR=1 is actually a pretty desirable equation. If the Fed could keep it there by interest rate manipulation, thereby limiting both inflation and unemployment to one-percent ups and downs, they'd be very happy campers.

Of course, they can't. Nothing in the real world works so nicely. Lag times may be longer or shorter than anticipated, there may be a terrible shock somewhere on the world stage, inflation may stubbornly continue despite an economic slowdown ("stagflation"), and the law of unintended consequences is always set to weigh in at any given moment.

What is clear is that the higher the SR, the more difficult it is for the Fed to engineer a positive result, with high and rising representing its worst nightmare. Today, the number stands at around 4, a high number that appears to be only headed higher. (In the mid-1980s, it was between 2 and 3.) It means, roughly, that if our time frame is a year, in order to bring inflation down by 1%, we will have to tolerate an unemployment jump of 4%.

Which is unacceptable, of course. It would require a huge boost to interest rates, and create a concomitant recession of dreadful proportion.

Ever wonder why the Fed has increased rates a skinny quarter-point per meeting? This is a big part of the answer, the time factor. Facing what it perceived as a dangerous inflation level down the road, it could have upped rates all at once, yielding a period of intense, concentrated economic pain, or done it in tiny steps, stretching the pain out over several years, at a less intense level. Otherwise known as the "soft landing."

Naturally enough, the Fed chose the latter course rather than commit collective suicide.

In the presence of an elevated sacrifice ratio, the choice was made to fight high inflation preemptively, rather than confronting it when it actually erupted and risking a severe economic dislocation. Additionally, the belief is that a policy of gradualism will also serve to lower the SR over time.

It might work; then again, it might not.

But one thing is for certain, the Federal Reserve Board--and especially Ben Bernanke, who takes the sacrifice ratio very seriously--will stay the anti-inflationary course.

And that answers the question posed at the beginning of this article. Whither interest rates? Up. Past performance suggests that the Fed, when it comes to the fork in the road offering a choice between Overshoot and Stop Short, has a pronounced tendency to head down the former.

So don't expect the FOMC to call a halt at the first signs of a slowing economy. The likelihood is that interest rates are headed higher, and for longer, than most people imagine. Until, perhaps, the sacrifice ratio begins to fall.


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