Fed Watch: Inching Closer to the Reality of Stagflation
Tim Duy assesses the Fed's options in light of the recent less than encouraging news on inflation and output:
Inching Closer to the Reality of Stagflation, by Tim Duy: There was virtually nothing pleasant about last week. At least, as far as the economy is concerned. The mass of data, the fresh instability in financial markets, and the latest testimony from Fed Chairman Ben Bernanke drove investors to the safety of US Treasury securities, all of which, at least at the short end, are yielding what must be negative expected real rates of return. Moreover, the odds now favor a 75bp cut at the FOMC meeting, a notch above the 50bp I am expecting. Not a surprise; the legacy of the past few months has been when you expect more, the Fed delivers. I am not ready to change my call at this juncture – I think it will be increasingly difficult for Bernanke to make the FOMC hawks choke down another big rate cut given the deteriorating inflation environment. And at some point, the Fed will need to hold their ground, or they will loose control of those anchored inflation expectations they claim to hold to dear.
The recent read on personal consumption and income starkly illustrates the Fed’s quandary- stagflation. Inflation has brought a halt to real spending growth, even as nominal personal income growth continues to edge higher. And lest we forget, this is no longer just about headline inflation; the three-month annualized core-PCE rate is now up to 3%:
With still surging energy prices, including gasoline projected to hit the $4.00 mark this summer, this story looks set to continue. Consumer confidence, unsurprisingly, tumbles. And we can expect that confidence will deteriorate further; the solid push above the 350k mark for initial jobless claims suggests the labor market is about to take a turn for the worse, while recent reads on manufacturing point to a weak ISM report. The only pseudo-bright spot in the week was that new orders for nondefence, nonair capital goods continue to move sideways, avoiding the sharp drops usually associated with recessions.
Bernanke appears largely resilient to growing inflation worries; the risks to growth are what capture his imagination. To compensate, Fed officials are pushing the story that they can quickly shift gears; market participants, by this logic, should expect policy symmetry. From Chicago Fed President Charles Evans:
Now if we took out such insurance too liberally or too often, then private sector markets would change their views regarding policy and alter their base level of risk-taking. But in doing so, we likely would observe inflationary imbalances emerging or unusual volatility in output. So part of our job as a central bank is to properly price these insurance premiums against the achievement of maximum employment and price stability over the medium term. Importantly, when insurance proves to be no longer necessary, removing it promptly and recalibrating policy to appropriate levels will reiterate and reinforce our commitment to these fundamental policy goals.
In a perfect world, this is true. The Fed would have learned not to revisit past mistakes, such as failing to quickly withdraw the emergency rate cuts of 1998 or holding rates at 1% for too long. The world as it is, alas, is far from perfect. It is simply easier to lower than to raise rates. And I suspect this is especially the case this time around, as even if inflation pushes higher a tepid economic environment – the best that even Fed officials see emerging on the other side of this slowdown – makes meaningful rate increases politically difficult. And, as I argued last time, any rate increases are effectively off the table for the foreseeable future, as Bernanke cannot offset the fiscal stimulus he supported and largely designed.
It is increasingly obvious that the Fed is in a no-win situation. The best case scenario for the Fed is that nominal wage growth is kept in check by a deteriorating labor market. This will help contain inflation expectations and prevent a more serious 1970’s type of environment. But overall, Jim Hamilton is correct; they are unable to both contain inflation and prevent a significant economic downturn:
In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.
The nuance I would add to Hamilton’s position is that monetary policy – as well as fiscal policy – is faced with the additional problem of a fundamental imbalance between production and consumption in the US. The US consumes too much to the tune of 5-6% of GDP, relying on foreign production to deliver the excess. Global financial markets, credit, commodity, and currencies all included – increasingly find it difficult to sustain this imbalance. Brad Delong hit the nail on the head in 2004:
That's the thing about accounting identities like S - D - I = NX. Either you craft economic policies that make them hold at full employment, or the market takes care of making sure that they hold for you--but usually not at full employment. Stagnant or falling wages that boost corporate profits could boost savings S by boosting retained earnings. A Bush administration serious about cutting the deficit could provide financing for investment and keep interest rates from rising. Big booms abroad could raise U.S. exports and reduce investment as the Fed took steps to shrink investment to avoid inflationary overheating. Otherwise, it is indeed hard to argue with Barry just across the north wall of this office: the dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat.
The Fed is currently in the “then repeat” stage, although driving down the Dollar appears to have accelerated the surge in commodity prices, while the near term impact on export growth will be hindered by the need for structural adjustment (if only we could export vacant houses). At this point, more policy thrown at impeding this adjustment will only yield more inflation. This may not be a problem for Bernanke, however, who as late as last September took a benign view of these imbalances. This benign view gave him the freedom to attack the credit crunch regardless of the inflationary consequences.
The inflation, of course, serves a purpose – it is a market response to excessive consumption. Policymakers who want to pretend that the fundamental economic problem is insufficient demand rather than excessive demand will find the market yields a solution – higher inflation to depress consumption via declining real incomes and wealth. Not a pretty solution, but a solution. Perhaps we are well past any other solution.
Bottom Line: I stick with the 50bp call because it is the most rational of the Fed’s likely options. 75bp, when the Fed knows they will have to deliver more, looks a little too risky given the inflation scenario and with the Dollar set for a new freefall. 25bp would simply be too much of a negative shock to deliver just weeks before the fiscal stimulus checks hit the mail. 25bp is not really likely; the debate is 50 or 75. Low real rates will eventually push investors out of Treasuries; I will leave it to the market strategists to tell you where the money will go.
Tim sends an update:
Update: Greg Ip at the Wall Street Journal also covers the stagflation story this morning. This passage, which I agree is an accurate assessment of Fed policy, is both enlightening and scary:
Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.
So far, they're still rising: wheat, oil and gold hit nominal records last week. But Fed officials don't think the latest jump can be justified by fundamental supply and demand. U.S. inventories of crude oil and gasoline are plentiful. Strong demand from China isn't new and should have been factored into prices long ago. A more likely explanation: investors, perhaps alarmed by the Fed's dovish stance, are pouring money into commodity funds and foreign currencies as a hedge against inflation.
Such fears can be self-fulfilling as higher food, energy and import costs work their way into consumer prices. But speculative price gains can't be sustained if the fundamentals don't support them. If the Fed and the futures markets are right, prices will be lower, not higher, a year from now.
The learning curve on Constitution Ave. is remarkably convoluted. The Fed wasn’t willing to describe either the tech or the housing markets as a bubble since it is not their job to define fundamental values, but apparently is eager to define the “fundamental” value of commodities, and quick to dismiss current valuations as a bubble.
What is clear is that the Fed remains eager to dismiss any inconvenient information. And, remarkably, a basic lesson that should have sunk in over the past decade is that even if you believe an asset bubble exists, it can continue for much longer than “fundamentals” would justify. Moreover, this piece reads as if there is no fundamental reason for the Dollar to be falling; instead, we are witnessing a bubble in all other currencies. Yet if I pull any international finance book off my shelf, I am pretty sure I can find some reference that the “fundamental” value of a currency has something to do with interest rate differentials. Not to mention the yawning current account deficit.
I hope the Fed is correct, and I will be the first to admit error, but for now I am not willing to dismiss the signals commodity prices, or the Dollar, are sending.
Posted by Mark Thoma on Monday, March 3, 2008 at 12:26 AM in Economics, Fed Watch, Monetary Policy |
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