OT...economy, feds, etc....
John
Ahead of the Curve
The Fed's Flawed Logic
By Donald Luskin Published: September 1, 2006
LET IT NEVER be said that Fed Chairman Ben Bernanke doesn't have a sense of humor.
After giving a speech Thursday, the event's moderator asked Bernanke if he'd be willing to take questions in a rather unusual way. He said, "Considering that these questions have been hermetically sealed in a mayonnaise jar and kept in the turban that Johnny Carson used in his Carnack routine, you could provide me the answer first and then I could read the questions."
Without missing a beat, Bernanke said, "All right, 4%."
The moderator was so stunned that a sitting Chairman of the Board of Governors of the Federal Reserve system would play along with his little gag that he couldn't come up with a question to match Bernanke's answer.
But it's interesting to speculate why, of all the things Bernanke could have said at that moment, he quoted an interest rate — and why, of all the interest rates he could have quoted, he quoted 4%.
Right now the market is so convinced that the Fed is done raising interest rates — and that its next move will be to lower them — perhaps most people would think Bernanke had in mind where the fed-funds rate would be a year from now. Today the fed-funds rate is at 5.25%.
But as soon as I heard that number, I thought of something else entirely. I think 4% is the core inflation rate we're going to be seeing a year from now. Thursday morning, core Personal Consumption Expenditures inflation — the Fed's preferred measure, which excludes energy and food — was reported at 2.4%.
In public the Fed is saying that inflation is headed lower. Maybe Bernanke's free association to "4%" reveals that, in private, the wise men who steer the Fed have their doubts.
Richmond Fed President Jeff Lacker has gone public with his doubts. He dissented in the FOMC's Aug. 8 decision to leave rates unchanged, and gave two very candid television interviews on Wednesday explaining that his inflation fears were the reason.
I think Lacker is right to be afraid. And I'm sure it's only a matter of time before the rest of the Fed comes around to his way of thinking. As readers of this column know, I've been warning about inflation for more than two years now.
For the moment, the Fed has ignored Lacker's view — and mine. That means when inflation mounts to a point where the Fed just can't ignore it any more — say Bernanke's "4%" — the interest-rate hikes are going to start up all over again. And they'll probably keep coming until the economy is thrown into recession.
Don't take any comfort from the fact that the price of oil has fallen so steeply over the last couple of weeks. Sure, it's great that it's down from last month's highs at $78 per barrel. At this writing, it's hovering around $70. And the price of gasoline at the pump has come down commensurately.
That ought to be great for the economy, and great for stocks. And indeed it will be — for a while. But, paradoxically, lower oil prices are playing right into the nightmare scenario that I see leading directly to recession.
I'm not so worried that $70 is still a high price for oil. Sure, it's just a couple dollars off the panic highs of one year ago, when Hurricane Katrina wiped out a huge chunk of domestic oil exploration, refining and distribution capacity. It seemed like the end of the world then. Yet now the same price feels like a relief.
But that's not the part that has me concerned. Our economy can handle high oil prices — and high oil prices are better than ultra-high oil prices. What worries me is how the Federal Reserve is going to react.
At first glance, it seems like it ought to be good news for the Fed. According to the Fed, high oil prices create inflationary pressures. Lower prices should ease those pressures. So, you might think that lower oil prices will help keep the Fed from having to raise interest rates any further.
But with the Fed, it's never as simple as it seems at first glance.
The Fed always says it's most interested in so-called "core" inflation, or inflation excluding energy and food prices. So, all else equal, when it comes to inflation, the raw price of oil hardly matters at all.
But there's another sense — a more indirect one — in which the price of oil matters very much to the Fed's outlook on inflation. The Fed believes that the oil price affects how much consumers spend and how fast the economy grows. Fine, that's true, although I think the Fed and most other observers exaggerate the importance of energy costs in the economy.
But here's where the problem starts: The Fed believes that increased consumer spending and rapid economic growth cause inflation. The theory is that when oil prices fall, people have more money left over to spend on cars, movies, furniture, whatever. The extra spending causes the economy to grow faster, which means there's even more money to spend. And all that spending supposedly causes prices to rise, and — voila — you have inflation.
Do you see how it works? As silly as it sounds, this means that the Fed believes that falling oil prices cause inflation.
It's not exactly quite that simple. The Fed employs an army of Ph.D. economists to make it more complicated. But when you strip away all their econobabble, that's what it amounts to.
So here's what's going to happen. Inflation is caused by the Fed printing too much money — period. They've been doing that for the last three years of ultra-low interest rates. That's virtually locked in a certainty that inflation will continue to rise for the next couple of years.
At the same time, the economy is going to reaccelerate. Actually, its recent weakness has been very much exaggerated. But now, especially with the price of oil coming off last month's highs, the second half of 2006 is setting up to be a time of very impressive growth.
The Fed is going to see inflation. The Fed is going to see accelerating growth. And the Fed is going to get scared.
They're not just going to "take away the punchbowl," as the old saying goes. They're going to smash the punchbowl. The result will be the same as it always is when the Fed gets scared: recession.
We're now in the last few months of the good times. As the economy accelerates, stocks should continue to rise. Make hay while the sun shines. But be ready to bail out. Midnight will toll sooner than you think.
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