Connelly on Commerce

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Today’s Federal Reserve Board announcement holding the Federal funds rate steady now toward a second year (the “pause” of last summer now clearly taking on a life of its own) seemed to include a subtle change in emphasis on what level of inflation is within the Fed’s famous “comfort zone”.  Such a shift would be particularly significant  with a Chair who explicitly favors inflation rate targeting.

Specifically, the Fed dropped the word “elevated” from its description of current inflation readings and substituted instead two new phrases: (1) that “core inflation” readings “have improved modestly” and (2)  that moderation in “inflation pressures” has “yet to be convincingly demonstrated”.

 Does this signify that, if the current rate of core inflation (down from 2.4% to clsoer to 2.2% in “recent months”)  stays put for a few more months,  the Fed’s “predominant policy concern” would no longer be “that inflation will fail to moderate as expected”? If that is the case, do we see a slight moving of the goal posts from a target of inflation  running “between 1% and 2%” — as most previous statements from Fed officials have suggested – to more like “around 2%”? That change would be significant, and perhaps would offer a more realistic “‘target” for an economy that carries the burden of world leadership in sustaining growth, if only because of its size.

Later this summer, the Fed will issue new forecasts for growth and prices, and we may see if Chairman Bernanke offers a forward vision that “splits the uprights” of the possibly new inflation goal posts. At about the same time, the minutes of this very interesting June Fed meeting will also become available for the markets to ponder. Meanwhile, there will be even more guesswork in the trading rooms of Wall Street — ironically in the wake of a two day Fed meeting that was particularly devoted to the issue of how to improve communication with the markets!

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The conservative, Oxford-based philosopher and historian (“Modern Times”) Paul Johnson popularized the  “rule of unintended consequences”, particularly in connection with offical governmental actions or legislation that tends to have effects in somewhat the opposite direction of what was intended. For example, the Clinton-era reform of executive compensation ”excess” (removing deductibility of salary compensation from corporate taxes if over $1 million annually)  leading directly to the explosion in stock-option based compensation “excess”. Similarly, the Sarbanes-Oxley reforms of corporate financial governance and public disclosure, leading directly to a raft (not to say lifeboat) full of companies ‘going private’ one way or another and thus reducing the net amount of public discosure. 

Is there another such “unintended consequence” occuring in the wake of the rush of Federal subsidies for ethanol fuels (including in last week’s Senate passage of an energy bill), but this time with a particularly odd twist?

Here’s the deal: We know that many of those concerned about US dependence on foreign oil supplies, and/or about fossil-fuel emissions and their contributiuon to global warming, believe the most effective break on our addiction to oil for automobile tranportation would be an increase in gasoline taxes, to assure a continued and indeed escalating price for traditional gasoline. But this solution has proven to be politically impossible to achieve.

Accordingly, ethanol-based fuels have been advocated as providing a “next-best” solution –an alternative source that would both improve the environment and hold down the price at the pump, which we know has been increased to some considerable extent not only by geopolitical considerations and trading patterns but also by lack of new refining capacity within the US.

But the response by major integrated oil companies and refiners to the continued rush of ethanol fuel subsidies has in fact been to put aside plans for additional refining capacity — a perfectly rational approach if the government is determined to provide subsidies for an alternative fuel. This in turn of course serves to put a (quite high) floor under the price of oil-based gasoline — exactly the effect that advocates of higher gasoline taxes seek to achieve!

Thus, even if governmental subsidies for ethanol-based  fuels do not provide (given their large production and transportation costs) an economically efficient replacement for foreign oil, they do seem posed to generate an “unintended consequence” — sustained high gasoline prices —  akin to higher gasoline taxes (of course, without the opprobrium usually associated with increased taxation). For your average politician, a good day at the office! The same goes for the environmentalist, the corn farmer, and even the oil refiners — a unique twist to Paul Johnson’s rule, which usually doesn’t forsee a “win-win” outcome. Of course, maybe the motorist is the loser.

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The treacherous US bond and stock market interactions over the past three days (June 6-8) almost make one forget that barely a week or so before, at least the public equity market seemed to believe in a renewed “Goldilocks” scenario — everything was turning out “just right”.

 The US economy was recovering nicely from the first quarter 2007 “bottoming” of GDP growth at .6%; inflation as most recently measured was coming off the boil and down closer to the Fed’s preferred range; the dollar was steadying in world markets; oil prices were at least in a relatively stable range betwen $62 and $66 per barrel; business investment was picking up after a slow start early in the year; solid job growth was continuing to underpin consumer sentiment and spending despite high gas prices and the persisting housing market downturn; and the Dow Industrials were setting record after record in a quickening march to “infinity and beyond”, or at least 14,000!

 None of that (excpet the Dow) had changed at mid-week. But quicker than you can say “Ben Bernanke” (or maybe “Bill Gross”), the ten-year note caught a serious cold and all of a sudden the stock market’s focus shifted from Goldilocks to the “Three Bears” — (1) interest rates; (2) credit liquidity; and (3) the possible end to the ongoing M&A boom triggered by low (1) and plenty of (2).  

The new trading hypothesis seemed to be:

(i) since the Goldilocks scenario in effect ruled out a Fed rate decrease in the forseeable future, maybe we need to start forseeing a possible Fed rate increase (look what the European Central Bank just did — although in truth that well-telegraphed move should have been no surprise to the market);

(ii) and as the bond market anticipates that Fed rate increase, we will quickly see yields on the ten-year benchmark shooting up to 5.25% and beyond — a direction-changing “higher-high” in the language of the chartists — that might well signal the onset of

 (iii) a credit crunch in the high yield and other money-pots feeding the leveraged buyout/share buyback phenomena central to the M&A boom (May 2007 witnessed the third-highest deal volume on record), which together have removed enough equity from the public market to keep a solid “floor” under stock market valuations.  

 But, at the end of the day, has Goldilocks really morphed overnight into her ursine archenemies? Or is there something more prosaic going on? I suggest the following:

 (A) The bond market is simply and grudgingly coming to the conclusion that the Fed and its new Chairman have been right all along about the economy’s resiliency, and that the bond market itself  has been wrong to trade at levels suggesting that the Fed ought to have been lowering the benchmark interest rate.

(B) Given a recovering but surely not overheating economy, it is past time for an adjustment to a more “normalized” (ie, not inverted) yield curve with long rates at least equal to short — and a return to “normal” at 5.25% for ten-year paper, after all, is not a portent of a credit crunch in any fair reading of recorded economic history.  

(C) The stock market meanwhile is shedding, in a healthy way, the element of complacency that was emerging in the daily record closes and preparing for a round of reassessments that will indeed get back to separating winners from losers, but not take down the whole shebang.

 Notably, if the Three Bears scenario were to take hold, it could be a self-fulfilling (and brutally self-correcting) prophecy. An interest-rate-induced credit crunch would surely trigger the debacle in the housing market that we have successfully avoided to this point: namely, a substantial downturn in the traditional (ie, non-”sub-prime”) mortgage market that could indeed wreck the economy (and of course bring down interest rates violently).

Net-net, then, the markets seem to have recoverd their perspective by week’s end, but have probably assumed a new “on the lookout” posture for the famous Three Bears — exactly what any smart Goldilocks would do when walking through the forest, especially in the summer, when the bears come out to eat.

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Golden Gate University’s Ageno School of Business in San Francisco — a hundred year old institution catering to the needs of working adults – has initiated a unique program that delivers a full-scale MBA cohort program for employees at Gilead Sciences, a leading publicly-traded biotech company in the Bay Area, conducted “onsite” at Gilead’s offices, so that the scientists, engineers, lawyers, clinical research staff and marketing professionals can expand their potential for managerial leadership while minimizing the adverse impact of educational commitments on both their family and work life. Gilead is supporting this investment in its employee’s future because it makes sense for the company as well.

The program takes 28 months to complete, only slightly longer than a traditional “two-year” MBA at an elite school. And most elite schools would be delighted to have the Gilead matriculants in their programs — in the first cohort, all had significant post-college work experience; 40% had advanced degrees; and there are 7 PhD’s in the mix! The students attend class at the office from 4 to 6:40 pm each Tuesday, then can head home or go back to their desks to participate in their second class for the week, which is taught entirely on-line. The two courses rotate between in-person and on-line format each week. Two such courses are completed in each of three 15-week trimester cycles during the year. This combination of timing and delivery allows for “catch-up” time when business travel schedules impact on individual schedules occasionally. Most importantly, participants can get home for dinner with their families despite their educational course load — which is not typical of working-adult MBA program structures, unless they are entirely on-line. Our “mixed-mode” delivery enables us to combine the benefits of cyber technology with the advantages of personal interchanges with instructors and classmates.

We have launched a second cohort, with a total of over 50 professionals enrolled at Gilead. The diversity of educational and workplace background in these cohorts matches up well with any standard MBA program.

Our program directly addresses work/family/career life as it is today with a view to giving participants more control of their own destiny — not only in long-term career sense — but also in a day-to-day, down to earth sense, because we have bent our academic “clock” and made our programs truly “portable” to practice the “customer-centric” approach to business that we in fact teach in our programs.

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