Sunday, April 13, 2008

The Federal Reserve's Gamble with Inflation Policy

The Federal Reserve's policy on inflation appears to be the hope that an economic slowdown will restrain price increases. Yet the Fed is doing everything it can, including the use of kitchen sink policies that it created on the back of an envelope, to prevent a recession. If the Fed is successful in accelerating the economy, it won't get the restraint on inflation that a slowdown presumably would have brought. In such a situation, it may have to raise interest rates rapidly to tamp down inflation. But rapid rate increases could undo the Fed's stimulus, sending the economy into a tailspin.

We have recently gotten some stern lessons about trying to be too clever by half. That's how the big banks in the derivatives markets managed to offload risk and send it on a circular path back to their own balance sheets. The derivatives markets are so complex and opaque that the banks didn't realize the horse they were buying was the same toothless nag they had sold last week.

Inflation is rising worldwide, with oil and food prices leading the way. In some nations, we're seeing a revival of old-fashioned food riots, the developing world's equivalent of a run on the bank. The nations that manufacture the goods sold in American stores are struggling with rising costs and are passing them onto the American consumer. Higher shipping and transportation costs add to the prices of manufactured goods. Foreign central banks are keeping interest rates comparatively high to combat inflation, thus protecting their own currencies at the expense of the dollar. The weakening of the dollar increases the cost of imported goods. This worldwide flurry of price pressures will pop a lot of holes in the dam that the Fed is trying to hold back.

Fundamental to the Fed's inflation policy is the premise that an economic slowdown will reduce purchasing power to the point where it discourages price increases. But let's remember where today's purchasing power comes from. Employment is only part of the picture. For many people, credit is the principal source of purchasing power. Employment can be the beginning point for an extension of credit. But the amount of purchasing power one gets from a credit card may be multiples of one's monthly income. (Compare your monthly aftertax income to the combined lines of credit on your credit cards, and you'll see what we mean.) Even if incomes are constrained by an economic slowdown, price increases can be absorbed by greater use of credit. Many banks are cutting back on the amount of home equity lines of credit. But borrowers can simply turn to their credit cards. Even if these are more costly, the low monthly payments required on credit cards mask and soften the real costs.

Thus, the oceans of credit available to the American consumer allow price increases to stick even as the economy slows. People will reduce big expenditures, such as the next car, a new and fancier refrigerator, or a home remodeling project. But they will, with some grumbling, be able to absorb the increased prices of bread, milk, gasoline, heating oil, natural gas, airline tickets and so on. Easy credit facilitates stagflation. When banks can borrow from the Fed at bargain basement rates and relend to credit card borrowers at rates sometimes approaching 20% or more, they enjoy a nice profit. They won't cut back on their profitable lines of business.

Things are nowhere nearly as bad as the stagflation hell of 1979. But that's not the relevant comparison. The appropriate analogy is to 1973-75, the beginning of the era of stagflation, when the first OPEC oil price hikes were followed by a faltering economy, a falling stock market and increased inflation. The Fed focused on stimulating the economy, keeping interest rates relatively low. The stock market revived, but only temporarily. By believing too much that inflation and recession are mutually exclusive, the Fed wound up having both to contend with. The painful resolution came five long years later, when Paul Volcker replaced Arthur Burns as Fed chairman and decided that the only way to true economic health was to suppress inflation by sharply raising interest rates, knowing that it would throw the economy into a nasty recession. That was the right decision, but it probably resulted in more pain than would have been suffered had his predecessor made the same choice five years earlier.

The Fed's current policy is to believe that we can have it all, even though its restraint on inflation is the slowing economy that it is trying to prevent. This may be plausible to those who believe up to six impossible things before breakfast. But some--call us the skeptics--tend to think that the Fed is rolling the dice for a hard eight (a Las Vegas term for the dice turning up four and four). This play might have a generous payoff. But the chances of winning are low and we, the people, will pay the price if the government is wrong.

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