The Fed Can Put Out These Fires
The Federal Reserve keeps plugging leaks in the dike, and investors keep worrying when the next one will pop. The Fed has filled the holes with $400 billion in various lending programs. Now comes a $30 billion loan, backed by securities of questionable value, to help JPMorgan Chase (JPM) lay Bear Stearns (BSC) to rest, along with a new overnight borrowing facility for key securities dealers—this one with no dollar limit. The capper: another big three-quarter-point cut in the Fed's target rate on Mar. 18, to 2.25%, making policy as stimulative now as it was after the 2001 recession. Constructive? Absolutely. But at what cost to the Fed's inflation-fighting credibility, so crucial to low market rates and a healthy dollar?
There is unease even within the Fed, given the two dissenting votes against the size of the latest rate cut. Investors appear to be treating gold and other commodities as hedges against future inflation. Some measures of inflation expectations, based on Treasury Inflation-Protected Securities, have picked up. The dollar has sunk to new lows vs. the euro and the yen, pushing up import prices. Producer prices in February rose a greater-than-expected 0.5% outside of energy and food. A few outspoken commentators are even saying the Fed should be raising rates.
Despite these concerns, the Fed will most likely emerge from the current mess with its inflation warrior credentials intact. One popular misconception is that the Fed's new lending programs aimed at restoring market liquidity are pumping massive amounts of money into the system. However, the Fed is offsetting these actions by simultaneously selling Treasury securities. That effectively neutralizes their impact on basic monetary policy.
More important, the credit crisis and the recession have built-in anti-inflation powers that haven't yet shown their full force. Even during the stagflationary 1970s and '80s, a slowing of inflation always came as a lagging response to an economic downturn, as weak demand depressed pricing power. Some moderation may be starting to show up. The February consumer price index was surprisingly tame, both overall and excluding energy and food. While import prices are growing faster, businesses' ability to pass along those higher costs to consumers will diminish as demand weakens.
Movements in commodity prices also tend to lag overall growth. The U.S.'s smaller role in global demand will limit that effect this time, but world growth is already slowing. Plus, because commodities are a small share of overall production costs, their fluctuations have little impact on consumer inflation outside of energy and food. Labor costs, which make up about three-quarters of all costs, are a far more potent fuel for inflation. But with payrolls falling, upward pressure on wages sufficient to sustain a wage-price spiral is highly unlikely.
In addition, bursting asset bubbles are deflationary events. Home prices are falling just as the value of tech stocks did earlier in the decade. As was true then, other prices will feel the downdraft. Moreover, a credit crunch as pervasive as this one also cools pricing pressures because it squeezes available credit, cutting into demand just as if the Fed were tightening policy.
In conditions like these, concerns about stagflation have little foundation: Higher inflation only sows the seeds of its own destruction, since rising prices cut into purchasing power and demand. Indeed, February retail sales fell 0.6%, and inflation-adjusted consumer spending is set to post its weakest quarterly showing since the 2001 recession.
All this means the Fed has the leeway it needs to battle both the credit crisis and the recession. Right now, the credit crunch is negating some of the stimulative effect of rate cuts, so exceptionally low rates will not be inflationary as long as the Fed raises them back to more normal levels once housing and credit markets stabilize. Leaving rates too low for too long after the 2001 recession was the mistake that fostered the housing bubble. It's one the Fed will not want to repeat.