The Feds Recent Rate Hike

Posted on by Joseph

So, things really are different this time.  The Federal Reserve Bank decided to raise its Federal Funds Rate on May 3 by a quarter-point, to 5.00-5.25 percent, in spite of a banking crisis that has seen three large banks fail in the space of six weeks, with remarkably little spillover into the economy at large. The misery mostly limited to shareholders in the banks concerned.   This is where rates sat before the financial crisis hit in 2008.

This recent rate hike has caused plenty of controversy as fears grow that further hikes risk tipping the economy into recession.  The inflation rate sat at 5 percent on the year in March, but core inflation (which excludes fuel and food) slightly increased in March, up to 5.6 percent. So, the Fed raised rates once again, in an effort to get price hikes under control, reiterating their focus on dragging inflation back down to earth even if it means tipping the economy into recession.

It should be noted that unemployment fell to 3.4 percent last month, matching the lowest reading since 1969.  So far, historically high inflation, slowed economic growth, increasing interest rates and banking turmoil has not cracked the still hot labor market.

For the past two decades, this sort of thing didn’t happen.  Under the unwritten laws of the “Greenspan put”, the Fed could be relied upon to provide some form of stimulus at the first sign of financial trouble.  It began with the collapse of the hedge fund Long Term Capital Management in 1998, when the Fed put together a $3.6 billion bailout funded by a consortium of banks, and it carried on long after former Fed chair Alan Greenspan himself had departed the scene.

Greenspan argued with monotony that “free markets are inherently self-regulating”, (like foxes are inherently the best guardians of chickens).  If markets wobbled, if banks got into a spot of trouble, an interest rate cut, or quantitative easing was never far behind.  He took the Fed in a direction quite different from the previous ruling guideline expressed by William McChesney Martin, Fed Chairman from 1951 to 1970, who’s famous for supposedly having said: “The Fed’s job is to take the punch bowl away just when the party’s going good”.  Or words to that effect.

Investors formed an expectation that the Fed would always help.  It was an Alice in Wonderland world where bad economic news often became good—good because investors calculated that the Fed would respond with a stimulus package.  By such means, the country ended up with the bubble economy of the past 20 years.

But this time around, the Fed has failed to oblige.  True, until the collapse of the Silicon Valley Bank, the Fed had been expected to raise rates by half a percentage point compared with the quarter point increase announced May 3.  But by raising rates at all the Fed has signaled that yes, it really did mean it when it said it was going to tackle inflation.  Not even falling US inflation has persuaded the Fed to take a break from its tightening program.  The Fed officials have said they want to see sustained evidence that inflation is moving toward their 2 percent goal.

The Fed finds itself in a tricky situation, having failed to act on price rises early on, so now they are playing catch up.  They were too late to the game to keep prices under control—having suffered a hit to credibility, have had to keep hiking rates, putting a damper on economic growth.  The Fed is clearly hoping this is the end of the line.

It softened its language in its statement after the May 3 hike, no longer preparing investors for further rate hikes, but rather noting that a myriad of factors—including economic growth—would feature in the “extent to which additional policy firming may be appropriate”.  In other words, interest rates may still rise, but it is by no means certain.  Ergo, only a naïve or ignorant person who say the worst if over.

Monetary Mischief

Posted on by Joseph

The past two and a half years have been extraordinary.  The unnerving combination of a global pandemic exacerbated by energy scarcity, supply chain disruptions, the return of inflation,  rising multipolar geopolitical tensions, and a new monetary era have people wondering what certainties are left. Still, in times of rapid change, it’s nice to know that some things stay the same.

Take The Federal Reserve for an example.  The Fed does not learn from its mistakes.  The Fed lost control of the money supply, causing inflation to soar.  In the two years following the March 2020 COVID-induced recession, the Fed allowed the broad money supply to expand by a staggering 40%.

It did so by keeping its policy rate at its zero-lower bound and increasing the size of its balance sheet by almost $5 trillion through its aggressive purchases of Treasury bonds and mortgage-backed securities.

In 2021, not hemming and hawing, the Fed kept assuring the American public that the inflation they were experiencing was a transitory phenomenon.  The Fed lost much credibility by failing to acknowledge inflation was surging back in 2021 and it is not obvious it has rebuilt its reputation.  This despite warnings that the explosion in money supply growth would take the country back to the inflation of the 1970s.

Not to forget, the Fed effectively pursued a policy of zilch interest rates or free money for 14 years since the 2008 financial crisis.  Individuals and institutions happily adapted to a universe in which money was practically free.  They forgot that free money turns out to be expensive. By failing to return the price of credit to something normal the Fed was fueling greater risk taking.

A sign of an intelligent mind is learning from one’s mistakes.  This is not the case with the Fed. The technocrats, the boffins, and the cognitive elites didn’t know what they were doing. Worse than not knowing what they were doing, Americans suffered big declines in disposable incomes over long period as a result of their policy choices. The economy did not deliver to the great majority of Americans the sort of life they wanted and hoped for.

People bought houses they could only afford with tiny interest payments, companies borrowed to buy back their own shares, investors borrowed to buy stock in a can’t lose stock market, and politicians ran up national debts whose servicing was only possible if interest rates remained negligible forever, putting the country on an unsustainable fiscal trajectory.

Then in 2022, the wise men at the Fed started raising interest rates at the fastest pace in half a century: 500 basis points in pursuit of lower inflation.  That is a lot to cram through the economy in a year and something just might break. And it did.  March madness was the appropriate tag line applied to last month’s scare provoked by the collapse of three U.S. banks as a result of rate hikes poor management, and the abject failure of regulators.

Of course, none of this would have been necessary had the Fed started tightening monetary policy a year earlier. The inflation was not transitory. It’s a bitter solace to savers that they can earn a meager say, 4.5 percent interest on their savings only now that, inflation being so high, that their funds on an inflation adjusted basis are still losing value and adding to the cost of living crisis for the ordinary American.

Ushering back in a new era of cheap money is by no means a requirement but would be a tempting one at that given how addicted to mass spending everyone has become.  But that if the Fed has learned anything would have serious repercussions.

Looking forward it may well be that in God’s newly automated earth, AI will offer a precious escape from the problem of setting interest rates, avoiding the friction and stress and politics which accompanies developing monetary policy.  Just as the intelligent ChatGPT is churning out poetry better than Milton,  surely this new technology can design, plan, and execute monetary policy in the future.   They are becoming quite good at that.

The Next Banking Crisis

Posted on by Joseph

When markets are in a “seek and destroy” mode, like the last dragon in Game of Thrones, it’s fruitless to guess where they might attack next in search of weaklings. But their next focus, alongside the impact of fast-rising interest rates on bond portfolios, may be commercial property and commercial real estate loans.

Concerns about a commercial office space crash have followed the collapse of Silicon Valley Bank, Signature Bank, and the regional banking crisis that began in early March. Federal Reserve officials have stressed that the collapse of these two banks had nothing to do with commercial real estate.

So often used for investment purposes, higher interest rates are making the commercial office property sector far less enticing.  Fast increases in the Federal Reserve Bank’s benchmark interest rate have led to significant shifts in customer behavior.  Institutional investors are shunning real estate for higher yields at lower risk on government bonds.

Fragility in parts of the banking system has not stopped the Federal Reserve from pushing up interest rates to subdue stubbornly high inflation.  The Fed recently voted to raise the benchmark borrowing rate by a quarter of a percentage point, the ninth increase over the past year.  That brought the fed funds rate to a target range of 4.75-5 percent, its highest level since late 2007. Another part of the motivation to raise rates might be to show—rather than simply tell—that the central bank has faith in the banking sector.

As property deals become more expensive to finance, the appetite for them wanes, which means fewer projects being built. Across, the sector, the Green Street Commercial Property Price Index is down 15 percent in a year, with the biggest drops in urban office real estate, where space stands empty as working from home takes permanent hold and people predict the death of the office.

U.S. office occupancy rates are between 40 and 60 percent of pre-COVID levels, according to the real estate firm JLL. Further, almost a quarter of the mortgages on office building must be refinanced in 2023, according to Mortgage Bankers’ Association data, which will bring higher interest rates.

COVID changed everything when employees were forced to work from home.  While some companies have pushed for a return to the office, others have adapted to the change and are allowing their workers to stay remote.  That is a bad sign for office owners.  As leases come up for renewal, many companies that have embraced work from home as the new normal will opt to terminate the leases.  That leaves some banks, especially regional ones, facing losses on real estate loans.

Consider that commercial real estate is a highly leveraged asset.  When mortgages on these properties mature and owners have to refinance, interest costs increase and adversely impact cash flow. Higher interest rates and more vacancies also decrease the value of some office buildings.  Indeed, some bank commercial office real estate loans may be threatened.

This is especially concerning for smaller banks, due to larger exposure as a percentage of their assets. For example, before its collapse, Signature Bank had the 10th-largest commercial real estate book in the United States. Another bank in the news, First Republic, had the ninth-largest loan portfolio in the same market.

According to Fitch Ratings “the office sector faces asset quality deterioration, putting smaller banks at risk.” It may turn out that the pretense that Silicon Valley Bank was a one-off is finished.

In 1992, Warren Buffet coined the phrase: “It’s only when the tide goes out that you learn who’s been swimming naked.” Now that the flood of cheap money has drained away and interest rates are on the rise, there may be more unpleasant revelations.

It’s unclear what the market dragon’s breath may scorch next.  But the next banking calamity may be commercial office real estate

It’s Déjà vu All Over Again

Posted on by Joseph

What’s telling about the Silicon Valley Bank collapse is that no one saw it coming.  When, on a visit to a London business school after the 2008-09 global financial crisis the late Queen Elizabeth asked why nobody saw it coming, no one had a clear answer.  Why, in a financial world crawling with regulators, did no one realize that subprime mortgages were toxic and on the brink of falling apart?

It looks like the regulators dropped their guard again.  Had they come to simply and blindly assume another set of false beliefs that ultra-low interest rates, designed to help tackle recession, were here to stay?

Entire business models were built on this assumption.  But then inflation returned and interest rates shot up.  And now we’re learning just how many banks bet the house on the idea that rates would never rise again.

Regulators closed Silicon Valley Bank, which catered to the tech industry for three decades, on March 10.  After an old-fashioned bank run, it did not have enough cash to pay its depositors.  It was the biggest bank to fail since the 2008-2009 financial crisis and the second biggest ever, after Washington Mutual fell in the wake of the collapse of investment bank Lehman Brothers, which nearly took down the global financial system.

During the COVID pandemic, Silicon Valley and other banks were raking in more deposits than they could lend out to borrowers.  In 2021, deposits at the bank doubled.

But they had to do something with all that money.  So they invested the excess in long-term ultra-safe U.S. treasury securities and mortgage bonds.  But rapid increases in interest rates in 2022 and 2023 caused the value of these securities to plunge.

The bank said it took a $1.8 billion hit on the sale of these securities and was unable to raise capital to offset the loss as their stock began to drop.  The bank’s client base, which included a lot of tech companies, exacerbated the problem.  Venture capital firms advised companies they invested in to pull their business from the bank.  This led to a growing number of the bank’s depositors to withdraw their money, too.  The investment losses, coupled with withdrawals, were so large that regulators had no choice but to step in and shut down the bank.

Despite being the 16th largest bank in the United States, Silicon Valley Bank was exempt from many stress- testing regulations other banks were compelled to follow.  It did its best to show it was one of the good guys.  Last year, for instance, it publicly committed $5 billion in “sustainable finance and carbon neutral operations to support a healthier planet.”

But how sustainable were the bank’s own finances?  It turns out its business model was hugely sensitive to interest rate hikes.  It had tied up its money in government bonds, which decrease in value as rates rise.

Here again the Queen’s question is relevant: Why did no one see it coming?  In this case, why was the bank so complacent in the year leading up to the crisis, when inflation was soaring?  And what other problems are lurking in the banking system as interest rates move back toward historical averages?

Silicon Valley Bank’s collapse highlights how blind regulators were to the scenarios that ultimately led to the bank’s demise—large and rapid increases in interest rates.  Do the Federal Reserve’s bank regulators not talk with or read about what their monetary brethren are doing?  Are the regulators fighting the last war, the last crisis?

More laws and regulations don’t always help if regulators are incompetent.  If they are, they should be terminated – along with the senior management at failed banks.

More on Stock Buybacks

Posted on by Joseph

Few corporate policies have generated as much controversy in recent years as stock buybacks.  If excessive compensation for senior managers is the most criticized use of corporate funds, stock buybacks may well take second place.

But like most controversial capital allocation decision, the details of stock buybacks are complex and nuanced.

Buyback opponents argue that the practice overwhelmingly benefits top executives.  Conventional wisdom is that buybacks give executives the opportunity to manipulate the stock price and, as some have argued, “create a sugar high for the corporation.”

Proponents of stock buybacks point out that share repurchases give companies the flexibility to return excess cash to shareholders. Moreover, companies may believe its shares are undervalued and are confident in its growth, which would make repurchasing shares a smart move.

Companies have no obligation to complete announced share buybacks, nor do they have to say when they have halted buybacks. They just stop buying shares.

In a share repurchase, a company buys back some of its outstanding shares, typically at a price greater than the going rate for the stock.  The shares are then retired or held as treasury stock.

Although there are several ways for a company to buy back shares, doing so through an open market repurchase program is the most prevalent. There are three other stock repurchase methods. One is a fixed price tender offer where the company offers to repurchase a specified number of shares at a single specified price.

Another method is a Dutch auction, in which the price is set at the end of a tender process rather than at the beginning. The company offers a range of prices set above the current market rate at which it is willing to buy back shares.  Shareholders submit their proposals by stating the lowest price they would accept and the shares they are willing to sell. The Dutch auction tender offer is executed at the lowest price that allows the company to repurchase the shares.

Finally, a company may contact one or more large owners directly and offer to buy back its shares from them. The share purchase price, in this instance, includes a premium.

In the past, companies rarely repurchased shares in the open market because of potential liabilities related to price manipulation.  However, a 1982 SEC rule provides a “safe harbor” for U.S. listed companies to repurchase their shares without being subject to liability for manipulation under the Securities and Exchange Act of 1934. The rule proved to be the catalyst for increasing share repurchase activity in the United States.

Companies buy back stock for many different reasons.  In addition to senior management believing the company’s stock is undervalued, they may have more money than available investment opportunities.  There may also be instances in which managerial compensation incentives such as earning per share may influence the decision to repurchase shares.  Of course, this aspect of share repurchases is rarely mentioned by corporate executives and lends some credence to concerns expressed by opponents of share buybacks.

Lastly, share repurchases may be used to counter a hostile takeover or greenmail threats, where a corporate raider acquires a large stake in the company in the open market and then threatens a takeover. Companies may use share buy backs as a defensive action to reduce the possibility that a potential acquirer would get a controlling interest in the company.

Share buybacks, like any other capital allocation decisions, can be problematic when used to prop up the stock without regard for the value of the company, are poorly timed or serve to increase compensation for company insiders.  All this is in contrast to dividends that are carefully considered, and predictable.  A whole lot of things have to go just right for share buybacks to be done properly.

Chatter About Stock BuyBacks

Posted on by Joseph

Before the 1980s, corporations rarely repurchased shares of their own stock.  But this year alone S&P 500 firms are buying back stock at double the pace of last year.  It is forecast that there will be at least $1 trillion in completed corporate stock buybacks by the end of the year.

All this despite a 1 percent tax included in the Inflation Reduction Act that went into effect on January 1 that is designed to slow stock buybacks.  Corporations that are awarded a piece of the $39 billion in grant money under the CHIPS and Science Act may also be barred from doing corporate stock buybacks.

Now the White House wants to further increase taxes on stock buybacks.  In his recent State of the Union address, President Biden said the tax should be much higher.  “Corporations ought to do the right thing.  That’s why I propose we quadruple the tax on corporate stock buybacks and encourage long-term investments.  They will still make considerable profit.”

That comment may have led the Oracle of Omaha, Warren Buffet, to weigh in on the hot button issue in the Berkshire Hathaway CEO’s annual letter to investors touting the benefits of repurchases: “When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).”

Still, Buffet included a caveat: he says buybacks make sense only if they are made at “value accretive prices,” i.e. when corporation don’t overpay.

Taking a step back, corporations have a number of ways to allocate capital:

  1. Make capital investments designed to grow their businesses. For example, buying new machinery or pouring more resources into research and product development;
  2. Acquire or merge with another company or business unit that the corporation believes could help grow its core business;
  3. Pay regular cash dividends to shareholders that tend to be more reliable than stock buybacks, an actual real return of cash to investors; and
  4. Use the money to repurchase their shares—a stock buyback automatically increases earning per share and has a stronger short-term impact with little, if any, tax consequences for shareholders.

As with many things in finance, the answer to whether stock buybacks are good for investors is “it depends.”

If a corporation sees its shares as undervalued and is flush with cash, a buyback could be a way to generate shareholder value.  A share buyback reduces the number of the corporation’s outstanding shares in the stock market and, theoretically, its share price should rise. Shareholders will own a bigger portion of the corporation and therefore a bigger portion of its earnings.

In theory, a corporation will pursue stock buybacks because they offer the best potential return for shareholders with relatively lower risk than other options for allocating capital.  When a corporation announces a stock buyback, it makes sense to ask if the firm believes its stock is cheap, or if there are other factors at play, such as senior management lining their own pockets in the case of a compensation incentive for executives based on stock price.

Also, investors are concerned if the stock buybacks are financed with debt, unlike dividends that are typically paid for out of cash flow, which makes the corporation’s balance sheet less resilient. Of course, it is a good sign if senior management is also buying company stock for themselves.

The tricky part in considering corporate stock buybacks is making sure senior executives are focused on sustainable long-term growth opportunities rather than increasing stock prices and engaging in share price manipulation while prioritizing the short-term.

Inflating Away the National Debt

Posted on by Joseph

Once again, the federal debt is big news, as lawmakers grapple with bumping up against the U.S. debt ceiling. The government has reached its borrowing limit, and House Republicans claim they will not vote to raise the debt ceiling and allow further borrowing without real spending cuts, not reductions in planned increases.

High government debt is a significant problem.  The higher the debt to GDP ratio, the harder it may be for a government to borrow by issuing bonds, and investors will demand a higher interest rate for what they view as a risky investment.

It’s also a political hot potato, but quick fixes come with big downsides.  Slow and steady may be the best solution.

The federal debt held by the public as a share of gross domestic product increased to 98 percent in fiscal 2022. For governments this metric is comparable to the debt-to-income ratio a lender usually wants to know before approving a loan. Think of GDP as the nation’s income.

It is also a key metric investor use to measure just how creditworthy a country is.  When the debt-to-GDP ratio is high, investors begin to question government’s ability to pay back the debt and start demanding higher interest rates.

The Congressional Budget Office forecasts that the federal debt will increase to 185 percent of GDP by 2052.  Spendthrifts have been ramping up deficit spending for a crazy long time – U.S. debt has increased more rapidly than national income for more than half a century.  To be sure, monetary policy has contributed to the debt; providing cheap credit by keeping interest rates artificially low for more than a decade.

Federal government debt increased by $2.5 trillion in the fiscal year that ended on September 30, 2022, from $28,429 trillion to $30,929 trillion.  Since the new millennium, the debt has increased from almost $6 trillion to nearly $31 trillion.

Governments have four tools to retire debt.  One is to generate higher economic growth by focusing on GDP.  Growth increases nominal GDP, driving down the debt to GDP ratio over time and reducing the risk of a debt crisis.

Another option is to reduce deficits by cutting government spending.  This is politically unpopular in the best of times and therefore unpalatable to politicians.  Taking away something the body politic regards as a “right” or an “entitlement” can be a career ender.

Raising taxes is somewhat less unappealing, especially on those the electorate views as “rich.”  The risk here is that raising taxes may reduce the incentive to work, causing tax revenue to fall, which would force government to borrow more and thereby exacerbate the debt problem.

One other option remains: inflating your way out of debt and debasing the currency through inflation.  High inflation reduces the real value of the debt, allowing government to pay it off with money that is worth less than when they originally borrowed it. As prices go up, so does GDP.  It’s a bit like a snake eating its own tail.

Inflation makes old debt easier to pay off, but it also makes new debt more expensive. That means higher inflation can lead to spiraling hyperinflation. Trying to inflate debt away is dicey; it is by no means a silver bullet.

But compared to the other options, such as getting spending under control, slow, chronic inflation as embodied by the Federal Reserve’s 2 percent annual goal may be the most politically palatable way to reduce the debt.

If all goes well, such an approach might produce the much ballyhooed “soft landing,” or getting inflation under control without triggering a recession.

FTX Collapse Another Regulatory Failure

Posted on by Joseph

Disgraced crypto tycoon Sam Bankman-Fried (SBF), a young man with Promethean ambitions, has been arrested for his role in the collapse of FTX, the virtual trading app he founded.  Prosecutors allege that he orchestrated “one of the biggest financial frauds in U.S. history,” using customers’ money to pay the expenses and debts of his hedge fund, Alameda Research.

The episode again raises troubling questions about the effectiveness of government regulators and the lack of regulatory oversight, despite many promises to bring crypto under their regulatory purview and avoid financial fraud.

Americans have gotten used to financial chicanery. They witnessed Bernie Madoff, who ran a multi-billion-dollar Ponzi scheme that wiped out the life savings of thousands of investors. Then there was the 2008 financial meltdown that cost millions of Americans their jobs, homes, life savings, and hopes for decent retirements. Many Americans never recovered from this cataclysm.

A grand jury in the Southern District of New York indicted Bankman-Fried on eight counts, including securities fraud, money laundering, and making illegal political contributions.  In total, the 30-year-old faces a combined maximum sentence of 115 years.

Following extradition from the Bahamas and his release on a record breaking $250 million bail bond, he has holed up at his parents’ $4 million Palo Alto home with an electronic monitoring bracelet while he awaits trial.

Bankman-Fried is also facing a civil case brought by the SEC, and possible civil actions by the Commodity Futures Trading Commission (CFTC) and state banking and securities regulators.

The house of cards collapsed when FTX filed for bankruptcy protection on November 11 with a reported $32 billion in debt. At the heart of the scandal lies a system for defrauding investors. Billions of dollars in customer assets have vanished, used to plug losses at Alameda Research, finance SBF’s lavish lifestyle, massive political contributions and bankroll his speculative’ investments.

FTX was a platform that let users buy and trade crypto currencies, such as bitcoin. The firm also minted its own digital currency called FTT and was big on environmental, social, and governance investments. SBF was a leading proponent of so-called “effective altruism,” a theory that advocates using “evidence and reason” to do societal good. He told the media he planned to give most of his wealth away to make the world a better place.

SBF donated almost $40 million to political candidates and political action committees in the 2022 congressional midterm elections. He was the second-largest individual donor to Democrats, trailing only billionaire businessman George Soros in the 2022 election cycle.

Prosecutors said one reason he made those contributions was to influence policies and laws affecting the cryptocurrency industry. There may not be a criminal trial until late 2023, legal experts say, because the government will need to build an extraordinary case.

Legions of criminal and civil defense attorneys will make bank by the time the dust settles.  Case in point, angry investors have already filed class action suits against prominent endorsers such as Tom Brady, Larry David, Steph Curry and Naomi Osaka, who all received equity in the company for failing to do due diligence before marketing FTX to the public.

The firm’s blue-chip investors included Sequoia Capital, Black Rock Third Point LLC, Tiger Global Management, the Ontario Teachers’ Pension Plan, SoftBank Group Corp. and Singapore’s investment company, Temasek Holdings.

Can there be any wonder why public trust is on the wane? The plain truth is that regulators exist to protect the interests of the regulated. Surely another special counsel is needed.

Closely related, American should be asking questions of politicians in Washington who sit on key financial oversight committees that were beneficiaries of SBF’s generosity. But that may be wishful thinking. Insulated from oversight and accountability, they will not be performing surgery on themselves anytime soon.

All of which brings to mind Honore de Balzac’s insight that “Behind every great fortune, there is a crime.”

Dec 7 A Day That Will Live in Infamy

Posted on by Joseph

Early in 1941, the government of resource-poor Japan realized that it needed to seize control of the petroleum and other raw mater sources in the Dutch East Indies (now Indonesia), French Indochina (now Vietnam and Cambodia), and the Malay Peninsula (now Malaysia).  Doing that would require neutralizing the threat posed by the U.S. Navy’s Pacific Fleet based at Pearl Harbor in Hawaii.

The government assigned this task to the Imperial Navy, whose combined fleet was headed by Admiral Isoroku Yamamoto. The Imperial Navy had two strategic alternatives for neutralizing the U.S. Pacific Fleet.  One was to cripple the fleet itself through a direct attack on its warships, or cripple Pearl Harbor’s ability to function as the fleet’s forward base in the Pacific.

Crippling the U.S. fleet would require disabling the eight battleships that made up the fleet’s traditional battle line.  But to be really successful, this alternative would also require disabling the two brand-new U.S. battleships then assigned to its Atlantic Fleet (which could be quickly reassigned to the Pacific), along with the three aircraft carriers in the Atlantic

It was quite a tall order.

The most effective way to cripple Pearl Harbor’s ability to function as a naval base would be to destroy its fuel storage and ship repair facilities.  Without them, the Pacific Fleet would have to return to the U.S., where it could no longer deter Japanese military expansion in the region during the year or so it would take to rebuild Pearl Harbor.

It soon became apparent that the basics of either strategy could be carried out through a surprise air raid launched from the Imperial Navy’s six first-line aircraft carriers.  Admiral Yamamoto had a reputation as an expert poker player, gained during his years of study at Harvard and as an Imperial Navy naval attache in Washington.  He decided to attack the U.S. warships that were moored each weekend in Pearl Harbor.

But in this case the expert poker player picked the wrong target.

The Imperial Navy’s model for everything it thought and did was the British Royal Navy.  Standard histories of the Royal Navy emphasized its victories in spectacular naval battles like Trafalgar, during which Royal Navy warships attacked and destroyed opposing ships.  Thus the Imperial Navy inevitably focused on attacking the U.S. Pacific Fleet’s battleships while at Pearl Harbor.

Lost in the shuffle was any serious consideration of trying to cripple Pearl Harbor’s ability to function as a forward naval base. So it was that, in one of history’s finest displays of tactical management, six of the world’s best aircraft carriers under the command of Vice-Admiral Chuichi Nagumo furtively approached the Hawaiian Islands from the north just before dawn that fateful Sunday, December 7, 1941, launched their planes into the rising sun, caught the U.S. Pacific Fleet with its pants down and wrought havoc in spectacular fashion.  On paper at least, this rivaled the British Royal Navy’s triumph at Trafalgar.

But so what?

The American battleships at Pearl Harbor were slow-moving antiques from the World War I era.  As we know, the U.S. Navy already had two brand new battleships in its Atlantic Fleet that could run rings around them.  And eight new ones the navy was building were even better.

More importantly, the Pacific Fleet’s three aircraft carriers weren’t at Pearl Harbor.  American shipyards were already building 10 modern carriers whose planes would later devastate Imperial Navy forces in the air/sea battles of the Philippine Sea and Leyte Gulf.  Moreover, the Air Force program was moving quickly to produce the B-29 bombers that would burn down 66 Japanese cities and drop nuclear bombs on Hiroshima and Nagasaki.

Most importantly, as the sun set on December 7 and the U.S. Navy gathered the bodies of its 2,117 sailors and Marines killed that day, all-important fuel storage and ship repair facilities remained untouched by Japanese bombs, allowing Pearl Harbor to continue as a forward base for American naval power in the Pacific.

So in reality, December 7 marked the sunset of Japan’s extravagant ambitions to dominate Asia.  Admiral Yamamoto and the Imperial Navy’s other tradition-bound leaders chose the wrong targets at Pearl Harbor.

The dictates of tradition are usually the worst guides to follow when it comes doing anything really important.  After all, if they survived long enough to be venerated, they’re probably obsolete.

Is the Fed Changing Course on Interest Rates?

Posted on by Joseph

There is a sliver of good news on the economy: inflation may be moderating.  For October, the consumer price index (CPI), a key inflation barometer, came in below expectations.  Though up 7.7 percent from a year ago, it’s the smallest increase since January.

But members of the Federal Reserve (the Fed) would be wise not to repeat their earlier mistakes by reading to much into a single month of cooling numbers.

You don’t have to be a professional economist to know that inflation is insidious for working Americans, as it erodes purchasing power.  For example, in 1970, the average cup of coffee cost 25 cents, by 2019 it had climbed to $1.59.  That’s inflation and it refers to price increases across the entire economy.

For decades, central bankers led by the Fed have flatlined interest rates and created money out of thin air, first in response to financial emergencies and then to the coronavirus pandemic. What were once emergency measures became totally normal, certainly since 2008. In simple terms, over the first two decades of the 21st century, the Fed engaged in a long love affair with ultra-low interest rates and printing money.

Easy money after the global financial crisis in 2008 produced several ill effects, including the creation of multiple asset price bubbles.  As one market analyst put it, “Never in the field of monetary policy was so much gained by so few at the expense of so many”.

But now Fed officials are walking back Fed Chair Jerome Powell’s hawkish comments in his briefing that followed the November Federal Open Market Committee (FOMC) meeting.  The Fed chair emphasized that it’s “premature” to discuss a pause in rate increases. He said the goal was to get inflation back to 2 percent, as the Fed announced an unprecedented fourth consecutive three-quarter interest rate increase, taking the central bank’s benchmark funds rate to a range of 3.75 to 4 percent.

This is the highest funds rate level since early 2008 and represents the fastest pace of policy tightening since the early 1980s, as the central bank tries to slow consumer and business demand and give supply a chance to catch up.

But multiple members of the Fed are now saying it looks like time to slow the pace of interest rate increases.  For example, the president of the Philadelphia Fed recently said the central bank should “pause when it makes sense”. Then the president of the Boston Fed said: “the risk of overtightening has increased”.

And the vice chair of the Fed says “soon” it would be appropriate to move to a slower pace on rate hikes.  The FOMC gets to see one more CPI report before its next meeting on December 13-14 to decide if it is time to pull back on the level of interest rate hikes.

These dovish comments are coming from the same grand poohbahs who 18 months ago claimed inflation was transitory as they sat on the sidelines and waited for it to abate.  They ignored the alarm bells and missed a crisis in formation.

Then, when inflation got out of control, the Fed finally tightened monetary policy. It was just a year and a half too late doing so.  As history has shown, printing too much money causes inflation.

Still, Fed officials convinced themselves that inflation was a thing of the past. The threat of inflation has faded from public memory. All this was before Russia invaded Ukraine.

The takeaway from all this is that the Fed will likely dial down the pace of interest rate hikes to a 0.5 percentage point increase in December after the recent encouraging signs that October inflation cooled more than expected. If this is the case, then it raises the question of whether the Fed has the minerals to stay the course and crush inflation.