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Monday, August 18, 2008

Fed Watch: The Knife Edge Cuts Deep

Tim Duy says "the economy will need to shift clearly in one direction or another – deflation or inflation – to drive any change in rate policy":

The Knife Edge Cuts Deep, by Tim Duy: The sharp decline in commodity prices has turned the tables on the inflation crowd, at least for the moment. To be sure, the most recent inflation report was none too encouraging, but as Jim Hamilton notes, it is largely old news. Indeed, bond markets appeared to react more strongly to higher than expected initial jobless claims. Headline inflation was a foregone conclusion, with rising core inflation an inevitable result of the spike in oil prices; while demand has been weak in the US, the depth of the downturn has so far been insufficient to forestall the pass through.

The Fed is powerless to prevent what will likely be a series of uncomfortably high core inflation readings in the month ahead. Expect little but lip service about “carefully watching inflation expectations” for now. Simply put, the case for a rate hike rested entirely on high oil and a weak dollar. Trends in these factors are cutting in the Fed’s direction in the last month, so much so that Across the Curve can posit the possibility that the next rate change will not be a hike:

Prices of treasury coupon securities posted solid gains today in a lackadaisical and lackluster trading session. The dollar continues to trade with new vigor and its strength debilitates commodities. I think that there is a bit of a slow and delayed reaction as participants realize that if the lower energy prices should stick that the Fed will eventually have room to lower rates…

The Fed is not there yet. They have been blindsided so many times over the past year that they will be hesitant to move dramatically on the basis of what could quickly reveal itself to be a temporary turn in commodity prices. More to the point, Bernanke & Co. view the economy as trapped somewhere between inflation and deflation, a knife edge that cuts deep into their policy options. The last FOMC statement was caught between these two outcomes, with the growth outlook diminished somewhat despite heightened inflation expectations. Interestingly, Federal Reserve Bank of Chicago President Charles Evans defines the current stance of policy similarly, stuck between the credit crunch and inflation:

Even though I think the current 2 percent funds rate is accommodative, it is not especially stimulative. This is because the financial market turmoil has meant that our funds rate reductions have led to less credit expansion to households and businesses than typically would be the case. Indeed, it has become increasingly clear to me that the fed funds rate alone is neither an adequate nor even an entirely appropriate tool for addressing instability in the financial markets. Further reductions in the fed funds rate could help provide additional liquidity to financial markets as a whole, but not necessarily to the most distressed portions of the market. And, in principle, if pushed too far, excess policy accommodation over an extended period of time would risk igniting inflation expectations.

Given the ongoing debate over inflation or deflation, is it any wonder that the 10 year Treasury is circling around the 4% mark? No clear direction in monetary policy equates with no clear direction for fixed income. Stuck in the mud.

So what will it be, inflation or deflation? Yves Smith is looking for some of each, a sensible conclusion. The inflation outcome – true, deep inflation – requires the Fed to turn on the printing presses aggressively. Only the threat of deflation would trigger such a policy response. Of course, it may be less of a threat and more of a “whiff,” as Fed Chairman Ben Bernanke likely has hair trigger when it comes to deflation.

In any event, inflation or deflation, I suspect Yves is correct when she claims:

But no matter how you slice it, the average worker is going to see his standard of living fall.

I also see this as the inevitable outcome of a global rebalancing of economic activity. But although pessimism is all the rage these days, I try to keep a little optimism at hand, recalling the tired but seemingly true words of Otto Von Bismark:

God has a special providence for fools, drunks, and the United States of America.

The adjustment is occurring – the inflationary burst from surging commodity prices easily overwhelmed the rise in nominal wages, depressing the ability of US households to spend, leaving year-over-real retail sales in negative territory. In my view, the financial markets clearly corrected an overly stimulative US response to the financial crisis. Still, this adjustment occurs, so far, without either runaway inflation or a collapse in employment. Something of a happy medium, at least if you admit that some adjustment had to occur. While we can bemoan rising inflation to date, the Fed probably had little choice but to accept at least some inflation as part of the mix; their dual mandate necessitates it as they cannot let the adjustment be borne on the labor market alone. This, of course, stands in stark contrast to the single mandate European Central Bank, which evidently sees less policy flexibility.

And, from a normative viewpoint, I suspect we are socially better off allowing inflation to impact real demand rather than forcing labor markets to bear the full adjustment. The former spreads the costs more broadly across the population, whereas the latter is concentrated among those unlucky enough to become unemployed.

Continuing to follow the middle road requires that policymakers keep a level head – neither trying to excessive stimulate the economy nor avoiding the necessity of providing appropriate support. The Fed is trying to stick to that middle road as well with policy that is little more than accommodative. The danger is political pressure or that Bernanke panics. Many feel that the Fed looked more to be reacting in a panic than deliberate leadership over the past year, and a persistent weakness in labor markets could place increasing political pressure on policymakers. Both will trigger monetary policy more likely to lead to inflation than deflation. For the time being, however, the Fed recognizes the dangers, and sees that rate cuts alone will not fix the financial turmoil of the past year. They will attempt to proceed ahead with rates at 2% while the US economy hobbles into 2009. The economy will need to shift clearly in one direction or another – deflation or inflation – to drive any change in rate policy. But without oil or the Dollar to restrain policymakers, the risk to stable policy is on the rate cut side of the coin.

    Posted by on Monday, August 18, 2008 at 12:24 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (12)


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