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Thursday, June 26, 2008

Fed Watch: This Is Not Good

Tim Duy says the Fed is in "something of an untenable position, to say the least":

This Is Not Good, by Tim Duy: Presidential candidate Barack Obama summed up the Fed’s dilemma today. From Bloomberg:

''The Fed is in a tough situation because it wants to control the inflation being caused by energy while at the same time trying to restore the economy,'' he said.

One tool, two objectives – something has got to give. The Fed is not blind to their dilemma, and today Fed Vice Chairman Donald Kohn said monetary policy has reached an impasse domestically, and implores emerging market economies to start doing the heavy lifting on inflation fighting. From the Wall Street Journal:

“The upward trend in prices of food and energy over the past several years…importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities,” Kohn told a monetary conference in Frankfurt.

And “in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability,” he said.

Kohn’s analysis sounds remarkably close to my own – Dollar bloc nations are effectively tied to Fed policy, and that policy is simply too easy for the those economies. But not to easy for the US, which puts the Fed in something of an untenable position, to say the least. Kohn is making an obvious effort to shift the blame for rising commodity prices away from the Fed, because, as is well know, it is never the Fed’s fault, whatever the problem (actually, the US Treasury deserves some of the blame, for using the IMF like a club during the Asian Financial Crisis).

Kohn’s is urging the Dollar bloc nations to raise interest rates while the Fed holds steady. This appears to be at odds with dollar supportive Fedspeak, although I suspect that rhetoric is largely directed at the major currencies. Still, could the Fed really want a fresh bout of Dollar weakness? Indeed, some Asian nations are already selling dollars to support their own currencies, even before Kohn’s speech. Interestingly, I suspect this will put the Fed into another inflation bind. If the Fed is correct and the rise in commodity prices, and specifically oil, is predominately due to global demand, rather than the Dollar’s decline, then higher rates abroad could help soften the foreign currency prices of commodities. But it is not inconceivable that a fresh bout of Dollar weakness raises the dollar price of those commodities.

In other words, the US has benefited by the foreign willingness to accumulate Dollar assets; it allows the US to consume well beyond productive capacities without, until recently, inflationary consequences. If the rest of the world is implored to tighten policy and weaken the Dollar, then I suspect those positive inflation dynamics will be reversed. The Fed effectively replaces one inflation concern with another by advocating what amounts to a Dollar drop.

In any event, it is not clear that the Fed can implore enough nations to tighten rates to have a meaningful impact on global growth. As Brad Setser reminds us, Dollar policy is inconsistent – the US government wants Asian nations to accept a weaker Dollar, but not oil exporters. And massive reserve growth in China suggests that nation is not interested in accelerating the appreciation of the yuan anytime soon.

Which is something of a good thing given that while Kohn is imploring the rest of the world to tighten policy and effectively let the Dollar go, the odds of a second stimulus package are rising. Obama again:

Democratic presidential candidate Barack Obama said the U.S. will continue dealing with ''short- term pain'' from an economic slowdown and the country needs a second round of stimulus checks to spur consumer spending.

''We know that consumer confidence is at all-time lows. We have to give people some sense that they could absorb the rising costs in gas, food and medical care,'' Obama said in an interview with Bloomberg Television today in Pittsburgh.

The US needs the rest of the world to buy that debt necessary to support the stimulus. If not China and the rest of the Dollar bloc nations, then who? Is it any wonder that financial markets are in disarray? From MarketWatch:

I can't remember the last time Dow futures in freefall the way they've been today," said Dale Doelling, chief market technician at Trends In Commodities. It's "an absolute boycott by buyers in stocks and the dollar."

But "the exact opposite happened in the commodity markets. You name it, oil corn, gold bonds -- everything up, up and away," he said in emailed comments.

Also providing support for oil Thursday, Algerian Energy Minister Chakib Khelil, who serves as president of OPEC, said oil prices could jump as high as $150 to $170 dollars a barrel this summer, according to reports.

However, he thinks crude will fall short of $200 a barrel. At a meeting in Paris, Khelil said a further fall of 1% to 2% of the dollar vs. the euro could add another $8 a barrel to oil prices. He cited the weakness of the greenback as a major cause of spiking oil prices.

The failure of the FOMC to issue a more hawkish statement weighs on the Dollar and pushes commodities upward, which only adds to the misery in US equities. But if the Fed hiked rates, financial markets might implode.

This is a no win situation...which way will the Fed turn? The Fed will hold the current policy in place until policymakers becomes sufficiently distressed by the impact of energy price inflation (September, October, next year; just not August). Note that market participants are increasingly aware that the Fed’s default policy for the time being is higher inflation, as evidenced by the rise in 10 year TIPS breakeven levels to 254bp today.

In theory, the best outcome is to find is a sweet spot that allows global growth outside of the US to decelerate while avoiding a free fall in the Dollar. In the absence of such equilibrium, the US economy can hobble along only as long as the following three conditions hold:

1. The Federal Reserve can maintain easy monetary policy.

2. The US government can sustain repeated fiscal stimulus measures.

3. China and the rest of the dollar bloc continue to be willing to accumulate US assets, primarily the Treasury debt needed for fiscal stimulus.

When these conditions no longer hold – such as the Fed needs to tighten to counter energy inflation, or the demand for US debt drops sharply – then I suspect the US economic environment will shift decisively toward higher inflation or significant recession.

Or both.

    Posted by on Thursday, June 26, 2008 at 03:33 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (35)

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