Monday, March 03, 2008

Stagflation threat looms over inflation hawks

Business Times - 04 Mar 2008

Stagflation threat looms over inflation hawks

Fed more fearful of fallout from housing crisis and its unknown backlash


When the second most senior man at the US Federal Reserve acknowledges that the rising cost of energy, food and imports are spilling over into the core inflation rate, even inflation doves get worried. Indeed, when Fed vice-chairman Donald Kohn expressed concern early last week that the 'higher costs of energy, a pickup in the prices of imported goods (as the dollar declines), and perhaps, the persistent upward price pressures in commodity markets may be passing through a bit to core consumer prices', some Fed watchers began speculating that the US central bank would be forced to take a break from its interest-rate cutting drive aimed at containing the threat of economic recession.

While, an annual rise of 2.5 percent in the 'core' consumer price index may not look like a danger to the economy, it is certainly of major long-term concern to America's financial institutions.

And there is little doubt that when it comes to the average American consumer, he or she does feel the pain in the form of declining purchasing power as a result of rising energy and food prices that have driven the broader measure of the CPI to above 4 per cent.

At the centre of the American consumer's concern are oil prices, which soared to over US$100 a barrel.

However, Federal Reserve chairman Ben Bernanke made it clear during his address before Congress last Thursday, that inflation remains a secondary concern for the central bank and it will continue to focus its attention on preventing an economic recession.

This means that the Fed is expected to continue slashing interest rates - which have already been reduced by more than 2 per cent - even if that plays into the hands of the inflation beast.

Indeed, Mr Bernanke hinted that another interest rate cut was expected in March as part of an effort to deal with the economic downturn driven by the housing crisis and the credit problems.

The Fed 'will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks,' Mr Bernanke said during his Congressional testimony.

The policy-making committee of the Fed will be meeting on March 18 and the expectation is that its members will reduce interest rates by another 0.5 percentage point.

'The economic situation has become distinctly less favourable' since last summer, Mr Bernanke said during a testimony before the House Financial Services Committee. 'The housing market is expected to continue to weigh on economic activity in coming quarters, emphasising that the 'challenge for us is to balance those risks and decide at any given time which is more serious'.

Mr Bernanke, who has been criticised for failing to take a pre-emptive action in dealing with the credit problems last year, could face similar criticism in a couple of months if the economy experiences rising inflationary pressures, fanned in part by the Fed's interest-rate cuts.

At the same time, the US could continue its slide into a deep recession, and create the conditions for the arrival of a third and even more frightening economic monster, the hybrid that combines recession with inflation, stagflation.

The critics will argue that the Fed may be playing politics. After all, the headlines in the newspapers are about American consumers and potential voters, facing the threat of housing foreclosures and credit-card delinquencies.

Hence, the public pressure is on the government and Congress - and the presidential candidates, one of which will become the boss of Mr Bernanke next year - to 'do something' to prevent recession and not to deal with the still amorphous threat of inflation.

So while conceding the rise in the prices of oil and food has worried the Fed, Mr Bernanke insisted that he and his colleagues were more concerned about the fallout from the housing crisis and its many and unknown repercussions.

Indeed, both in Wall Street and in Washington, the perception is the financial markets 'continue to be under considerable stress', as Mr Bernanke put it, during his testimony. The main fear is that due to some unforeseen developments - like the collapse of a huge financial institution - the financial markets could experience an horrendous meltdown.

From that perspective, the Fed's interest-rate cuts are driven by an immediate threat to the economy and not by political calculations.

But the problem is that neither the Fed's monetary policy nor the US$168 billion economic stimulus package approved by Congress is having any immediate effect on the economy. If anything, as the Fed's vice-chairman Kohn noted last week, the downturn in the housing market 'appears to have spread to other sectors of the economy'.

According to reports, mortgage defaults and home foreclosures have risen by close to 60 per cent in the last 12 months. And the decline in home prices is continuing to accelerate and is making it difficult for home-owners to borrow against the value of their home, which was one of the major sources of credit for many Americans in recent years.

The stimulus package's rebate cheques that these Americans will be receiving in the spring are not expected to compensate them for the loss of their home's equity.

Responding to the concerns about stagflation that have been expressed by economists and lawmakers, Mr Bernanke stressed last Thursday that the American economy was not heading towards a 1970s-style stagflation.

'I don't anticipate stagflation,' he told lawmakers. 'I don't think we're anywhere near the situation that prevailed in the 1970s.'

But the Fed will probably start getting worried about the prospects of stagflation if unemployment starts experiencing some weakness.

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