Will the Fed be left holding the kitchen sink?
There are many barometers of the financial health of the nation. One should never commit to just one of them, because the economy is a complex entitity, but rather keep tabs on a basket of metrics. One under-appreciated metric I call the Larry Kudlow Demented Optimism Measure (which could, if one added some other words, and took some away, and rearranged them, allow for the initialism ‘KONDOM’). Larry Kudlow is by nature an optimist; tell Kudlow that your mother just died and he’ll tell you not to worry, everything’s great and if the government will just cut taxes, everyone’s mother will be resurrected by year’s end. Consequently, when Larry Kudlow is worried, you know that sane people should be worrying too. In particular, while doing his normal mix-and-match of economy and demented politics, Kudlow is finally concerned about inflation. Don’t take my word for it, take his:
Consequently, for the first time in a decade I’ve become genuinely worried about inflation. Over the last year and a half, consumer prices have climbed from 1.5 percent to nearly 4.5 percent. Prices are rising today faster than average hourly earnings for the non-management workforce. As real incomes go down, so goes the consumer.
If this was a John Edwards speech, we’d soon be treated to a “Two Americas” monologue involving poor working mothers and heating bills, but Kudlow’s finally worried about the dollar being in the tank:
And if all this weren’t bad enough, the falling greenback is becoming a symbol of American decline. Folks are making fun of the dollar. Our enemies around the world are pointing to the unreliable dollar as evidence of American weakness. Weakness as a financial power. Weakness as a national-security power. Does an unreliable currency symbolize an unreliable nation?
Leaving aside Kudlow’s somewhat bizarre attribution of the Great Satan’s current image problems abroad to the decline of the dollar, there’s no doubt that there are inevitably problems for the US when it effectively, thanks to its weak currency, becomes poorer on the world stage. It’s fears of inflation, however, that are of concern to me at the moment.
I mentioned before that the mortgage market isn’t responding to lower Fed interest rates, including the surprise three-quarter point slashing of rates in January, by significantly lowering their own lending rates, because they fear that inflation will cut their returns and so are charging higher interest rates to buttress those returns. The problem here, of course, is that Fed rate cuts are, themselves, inflationary and thus in part causing the fears to which the lenders are responding.
This means that homeowners in trouble are still going to be in trouble, as are people planning on becoming homeowners and that’s before we even consider that the Fannie Mae ‘adverse market surcharge‘ has just come into effect in March. This stuff is important because US economic growth has been in large part propelled by rising house prices; no one could hope that would go on forever and the universe still remain a place of finite resources, but the different between resuming sane growth in prices and prices crashing is big in terms of confidence and, consequently, consumer spending; furthermore, the price of housing will only fall more as houses are reposessed, which will put more people into negative equity and therefore more likely to default on their loans (just based on psychological factors; why struggle to meet loan payments when what you bought with the loan is no longer even worth what you owe?) and in any case hammer the prospects of the lenders and those that own financial products based on these loans. Consequently, the whole thing can get a lot worse and take the economy down with it.
The BBC’s business editor Robert Peston has been covering the global effects of this in his excellent blog and last week he gave some illustrations of how the problems are spreading and also shows why, at this stage, we don’t know how bad it will get. In the upate to that post, Peston reported the $200 billion cash injection from the Fed into the banking system, which buoyed the Wall Street exchanges today (although I’m not entirely sure why this caused such a positive reaction today if Peston was able to report on it last week, unless the timestamp for the update is wrong and it was made today: Update That was a different $200 billion, my mistake; the $200 billion from yesterday was the Fed letting people use mortgage debt as collateral for buying US Treasury securities) but how many more tricks does the Fed have up its sleeve?
My concern is that if the collection of Fed actions do no more than temporarily arrest a slide to recession, whilst at the same time loosening the bounds on inflation, that the Fed will have thrown everything but the kitchen sink at the problem to no avail. In that event, the Fed looks, and more importantly is, pretty powerless and there’s then little hope of a soft landing. There’s plenty of mileage in arguing the rights and wrongs of the Fed’s actions so far but I am not sure what else the Fed can do from where we currently are and I can’t believe that the “stimulus package” rebates are going to save us. In the end, it may be us left with our hands full of mixed metaphor.
It’s too bad we didn’t have any presidential candidates who understood or cared about inflation. That would have been awesome. I bet everybody would have voted for him.
Comment by Redland Jack — 3/11/2008 @ 2:54 pm
Inflation is much out of relatively direct Presidential control unless he wants to do something crazy like abolish the Fed and institute lunacy like a return to the Gold Standard.
Of course, stuff like the weakening dollar is in large part in government control because of effect from, for example, the budget deficit. Oh, if only we had a deficit hawk running for President. No, wait.
Comment by Adam — 3/11/2008 @ 2:59 pm
Inflation is much out of relatively direct Presidential control unless he wants to do something crazy like abolish the Fed and institute lunacy like a return to the Gold Standard.
Please Adam. You sound like a Republican shill on that one.
The president appoints the Fed Chairman. If the Fed Chairman F-ed up, then the President in the only one the voters can hold responsible, as they have no other influence on the Fed.
The President and Congress also pass laws that regulate the banking industry in general.
Comment by daveg — 3/11/2008 @ 3:28 pm
A President can certainly exert influence on fiscal policy through leadership on tax and spending issues. Monetary policy is a gift horse of another color which can be led to water but not forced to drink.
Comment by Rojas — 3/11/2008 @ 3:34 pm
Daveg, that is why I used the word ‘direct Presidential control’.
The President appoints the Fed chairman pursuent to Senate approval. That’s not what I call ‘direct control’ over interest rates and inflation. I also left open the question of whether the Fed had seriously screwed up and, if it did, whether Greenspan owned more of it than should Bernanke; as I said in my post, there’s a lot of mileage in that sort of argument but it’s not a particularly simple argument. It is certainly not the one I was framing in my post, which was about whether the Fed, for whatever reason and for whoever’s fault, was like to be a hapless bystander regarding the current economic trajectory.
I understand that the government has many and various roles and effects regarding the economy, both the Presidency and the Legislature (and, consequently and inevitably, the Judiciary) but the idea that the government is somehow in direct control of the economy is something I’d expect to see more of from populists and socialists. I linked before the interesting Samuelson article about the disparity between what Presidential candidates like to claim they can do to revive the economy and what they can actually do, which is pretty much all indirect and slow.
Comment by Adam — 3/11/2008 @ 3:40 pm
Indeed. But we’ll jump off that bridge when we come to it, if all of our friends do.
Though never into the same river twice.
Comment by Rojas — 3/11/2008 @ 3:42 pm
I’m still waiting to hear McCain’s plan to balance the budget. I mean, I know that he “doesn’t really understand economics,” but I would imagine he understands that lowering taxes and raising spending isn’t going to cut the deficit. $18 billion in earmarks and $16 billion in farm subsidies isn’t going to get him there.
Plus, you certainly don’t need to go to the gold standard to have a low inflation rate. If the Fed and the government would quit cooperating to “fine-tune” the economy, we could settle on a simple monetary rule tied to growth in GDP that would establish the growth rate of money.
Trying to have a coherent, discretionary monetary policy in a country as large and disparate as the U.S. doesn’t make any sense, anyway. The economies of Michigan, Georgia, New York, and Washington State would need different fine-tuning.
Comment by Redland Jack — 3/11/2008 @ 3:52 pm
My understanding is that McCain wishes to start lowering spending in real terms. Of course, that’s the sane thing to do and I support McCain, so perhaps I am just projecting…
There certainly isn’t going to be a return to balanced budgets in the short term, but the structural and rhetorical changes which need to take place can begin come November.
I don’t know that he’s promising to ‘lower taxes’ as such, although in terms of seedy budget predictions, making the current tax cuts permanent will comprise a cut in taxes. Given the damage that restoring the tax rates will cause, however, I don’t see that there’s a great deal of choice but to substantially keep them (and the Democrats are basically in line with that too, although they plan to soak the rich by letting their tax cuts expire).
I don’t think that what you need is a simple monetary rule to control inflation. What you need is a focus on inflation when setting interest rates, based on a wide-ranging view of the markets; that’s what Volcker had and that’s what Bernanke prefers and it’s hardly fine-tuning (in fact, it’s a damn big stick and it has to be used with great caution). It’s the 14+ years of Greenspan in the middle that I’ve been a little concerned about, to be honest; he did some clever work but also some dangerous work, in my opinion. My concern about Bernanke is that he has abandoned his prior preferences, although if he is right about inflation dampening amidst slowdown then what he’s done is, in fact, fine.
Comment by Adam — 3/11/2008 @ 4:01 pm
Ah. I should also add, that while I agree that the government can do very little to help the economy, almost everything it does can hurt it.
Also, when the government spends 20% of GDP (is that reasonably accurate?), I’d say that it does have a lot of control over the economy.
Comment by Redland Jack — 3/11/2008 @ 4:04 pm
20% of GDP sounds about right (and it’s over 100% of government revenues, of course). I wouldn’t call that ‘control’; it certainly does, however, have a lot of effect on the economy.
As a recent interesting illustration of which Presidential candidates are on the taxpayer’s side, the Boeing-EADS bitchfest is a good one. Whilst Obama and (particularly) Clinton and a host of other legislators from both parties seem to think that multibillion dollar no-bid contracts for US firms to supply the US military are a good idea, McCain is the one that’s been pushing an open competition to get good value for taxpayer money. Of course, Jack Murtha, the old whore, is threatening to put the deal into the toilet before he sees the US taxpayer get the best product for their dollar whilst apparently under the impression that the real villian of the piece is John McCain, who helped get the competition opened after Boeing’s corruption came to light.
Comment by Adam — 3/11/2008 @ 4:09 pm