Why Bernanke Faces Stiff Headwinds

Credit tightens, inflation rises as businesses and households feel scant relief from the Fed's rate cuts. That doesn't bode well for recovery

So far in 2008, little seems to be going right for the U.S. economy or for the Federal Reserve's efforts to keep it on course. In fact two very important things are going in the wrong direction: inflation and long-term interest rates. The price of oil was expected to level off or decline by now, not soar back to $100 per barrel, and slower growth was supposed to keep a lid on other prices. Instead, inflation in January picked up steam, even outside of energy. More importantly, while the Fed's January cuts, unprecedented in their size and speed, were supposed to ease borrowing conditions for businesses and home buyers, credit has tightened further.

During his semiannual testimony before Congress on Feb. 27-28, Fed Chairman Ben Bernanke said nothing to dampen expectations of further rate cuts. However events appear to be overtaking the Fed as its policy-easing struggles to show results. Credit tightening is spreading beyond subprime-related financial instruments to the debt offerings of healthy companies and prime mortgage borrowers. The danger, as policymakers said in the minutes of the Fed's last meeting, is an "adverse feedback loop."

That is, tight borrowing conditions depress profits and incomes, broadly eroding the credit quality of businesses and consumers, thus further constricting banks' willingness to lend.

Investors Averse to Risk

Those worries look increasingly justified. Despite the Fed's cuts, the rate on a somewhat risky but investment-grade BBB-rated corporate bond stood at a 4 1/2-year high of 6.95% on Feb. 20. Compared with a riskless Treasury bond, the spread between the two yields is the highest since the 2002 corporate scandals. The same is true for an AAA-rated bond. These spreads indicate a broad and intense aversion to risk among investors, even for the debt of sound companies.

In addition, in the weeks since the Fed cut its target rate by 1.25 percentage points, 30-year fixed-mortgage rates for prime borrowers have risen 0.8 points, to 6.3% by Feb. 22. The spread vs. a Treasury yield is the widest since the temporary spike after the debacle at Long-Term Capital Management in 1998. Sales of existing, single-family homes held steady in January, and their rate of decline has slowed markedly in recent months. However costlier mortgages and extreme risk aversion in the secondary mortgage market, even for prime loans, could result in new sales weakness during the important spring buying season.

Now comes higher inflation. Price worries are another risk that investors have built into interest rates in recent weeks. Currently, the Fed is less concerned about inflation, because policymakers believe it will eventually recede in response to a weak economy, as it has in the past. In the here and now, though, consumers are losing buying power even as job markets weaken. It's little wonder that consumer confidence plunged to a five-year low in February. Since last summer energy has helped push up the consumer price index at a 5.6% annual rate, far faster than the 3.8% rise in wage and salary income. After January's 0.4% increase in consumer prices, inflation-adjusted income began this quarter below last quarter's level.

The disturbing aspect of the January price rise was its breadth, which went beyond energy and food, with large hikes in clothing, medical care, air fares, and hotels. The broad gains suggest companies are passing along higher costs for energy, foodstuffs, and imports to consumers. With the cost of oil, raw materials, and nonfuel imports far above fourth-quarter levels, and with the January jump in producer prices showing more price pressure in the pipeline, household incomes will remain squeezed.

Bernanke told Congress the Fed "will need to judge whether the policy actions taken thus far are having their intended effects." This nasty mix of higher rates and inflation is clearly unintended, since it works against an easing of the drags from tighter credit and the housing slump. That means Bernanke & Co. will be fighting an uphill battle in the months ahead.

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