Monday, November 3, 2008

Can the Federal Reserve Handle the Volatility?

As we discussed in our preceding blog, volatility in the stock market discourages investors. Buy and your investment suddenly drops in value. Place an order to purchase, and the market jumps before your order can be executed, causing you to pay more. With investment opportunities like these, you might prefer to sit in front of the TV, drink beer and eat potato chips. Better to pork out than take trading losses.

Volatility is also a macro-level problem. Two months ago, the Fed had to be cautious about lowering interest rates because of the high price of oil. The dollar was in the doldrums, adding to the inflationary pressure. Today, oil is regressing back to 2005 levels, and some low tax states may soon see gas under $2 a gallon. At the same time, the dollar has rebounded briskly against the Euro (although it's slumping against the yen). The Fed is now concerned with deflation--that rarely seen phenomenon where overall price levels fall. Deflation discourages consumption, because consumers wait for prices to drop before buying. Inventories pile up, manufacturing slows down and layoffs increase. Debt becomes more burdensome to repay, since borrowers must use more expensive dollars to pay their obligations.

In order to forestall deflation, the Fed lowered interest rates recently, a measure that is also meant to stimulate the recessionary economy. Monetary policy tends to take effect at a glacial pace. Interest rate changes often require 12 to 18 months to have a significant impact. Do we really think that oil prices will stay low for the next 12 to 18 months for the convenience of central banks around the world? Or is it possible that they may pop unexpectedly, as they did this past spring? Could the dollar slide again when investors get a fix on the size of future U.S. government deficits after the costs of all the bailouts and lending facilities becomes clear? The recent federal bailouts and interventions have, if anything, only increased America's status as the biggest spendthrift of all. This isn't good for the dollar.

Will the Fed be able to handle the unexpected volatility that we now know to expect? Will it be willing to change policies if a few months from now inflation, not deflation, turns out to be the problem? Events in the current financial crisis have moved very fast, and the government has been forced to improvise extemporaneously. At this point, its response consists essentially of just one measure: pumping as much liquidity into the financial system as fast as it possibly can. Methadone does work, in a manner of speaking. But it substitutes one addiction for another and the financial system is now addicted to government interventions and bailouts. The stock markets surged last week amidst a sequence of coordinated worldwide interest rate cuts. But you can't have a financial system that's all government all the time. The Soviets and Communist Chinese tried that idea and it didn't work out so well. One scary scenario is that the stock markets might soon bubble up on a cushion of government interventions and become disconnected from economic reality. The disconnect with reality has happened in the recent past--in the real estate, mortgage, and derivatives markets. Re-connecting was painful. Let's hope that the stock markets' current frothiness isn't irrationally exuberant.

All of the economic news from last week went from bad to worse. The nation's slide into recession may be sharper than the stock market expects. Layoffs are increasing quickly. Consumption is falling as people are actually saving. This is really weird. When Americans start saving, you know times are tough. The full picture may not have shown up in current official statistics, but it would basically take the appearance of the Yeti on people's front lawns to get red-blooded Americans to save. But they are, and that means, aside from confirmation of the existence of the Yeti, that we're probably in for a full-bore recession, the kind where parking enforcement officers find deep in their hearts the compassion to overlook illegally parked cars with people sleeping in them, close to where the soup kitchens are located.

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