07 August 2008

Decisions, decisions...

"With mounting inflationary pressure, the Fund added: “Policy trade-offs between inflation, growth and financial stability are becoming increasingly important.”"

This is from an article in The Financial Times covering the outlook offered in a report issued by the International Monetary Fund concerning the credit crunch.

What I see happening is high commodity price inflation combined with a now risk-averse financial system and limited economic growth in the U.S. because of dampened consumption. We've been financing our consumption for the past decade or more, so now that we can't borrow anymore consumption will fall and the economy will slow or stall. Cutting the federal funds rate in an attempt to affect real interest rates hasn't had much impact and probably won't while the general outlook for lending and investment remains extremely risk-averse. The Federal Reserve has maintained financial system stability through the use of new tools such as the TAF, the TSLF and the Primary Dealer Credit Facility as well as the Bear Sterns bail-out...but preventing a meltdown hasn't restored confidence in the markets to previous levels.

So, consumers can't borrow to consume and firms can't borrow to invest and the result is declining consumption and crawling (if not negative) economic growth. Rapid and sustained commodity price increases are driving inflation upward (let's hope the weak labor market constrains wage growth, otherwise a wage-price spiral will be the next calamity). And maintaining financial system stability isn't restoring confidence in the basic ability of the financial system to channel funds from savers to borrowers.

The Federal Reserve is trying to juggle a few balls at once, and the appropriate response to these problems isn't easy to come by.

Lowering the federal funds rate further probably won't have much of an effect considering the fear of risk in lending right now; the net effect on the economy would be nil, so this isn't really an option (or one with any impact, anyways).

Raising the federal funds rate would drive real interest rates higher than they otherwise would be in the current situation, further curtailing growth, but at the same time relieving the upward pressure on prices and thus constraining inflation (before long-term inflation expectations become unanchored) and restoring some faith in price stability. This is a possibility, but the cost is slow or negative growth (and rising unemployment). The FOMC expressed concerns about both growth and inflation in it August 5th policy statement, but didn't say which was the priority at this time. Personally I would argue that inflation should be the priority right now. I say this because inflation expectations are very difficult and take a long time to cement. If inflation expectations are unanchored now it could take 10 years to correct, making it difficult for growth to occur during that time because of uncertainty about prices and interest rates offered on loans.

Growth can bounce back and forth relatively quickly, compared to inflation expectations. Raising rates might not be such a bad move.

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