Fed Inaction Was the Right Move

by: Ockham Research posted on: June 25, 2008    
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Today the Fed’s Open Market Committee [FOMC] met to discuss monetary policy and did what was widely expected—nothing. By holding the fed funds target rate at 2%, the FOMC is breaking its streak of seven straight meetings with rate cuts. Since late last summer, when the credit crisis first started to impact the financial markets, the Fed lowered rates aggressively from 5.25% down to 2% over the course of nine months.

Those rate cuts appear to have helped the economy avoid the worst of the possible credit crisis scenarios and now the greater concern for the economy is inflation during a period of slow economic growth. There are bound to be critics of the FOMC’s decision—because there always are—but it was likely the correct path at this time.

There are some who would have liked to see the Fed take a firmer stand in the face of rising inflation, among them Dallas Federal Reserve Bank President Richard Fisher who was the single dissenting vote–his fourth straight dissent. Raising rates at this point in time would be very problematic for the overall economy and would most likely be disastrous for ailing banks and the seriously troubled housing market. Banks desperately need to rebuild their capital base and higher interest rates would severely complicate an already ponderous task. With each week bringing grimmer statistics regarding housing, that market has not yet stabilized enough to absorb higher interest rates.

The FOMC is trying to balance these concerns with diametrically opposed views of many on Wall Street who believe that continued easing is required in order to propel the economy out of its slump. While the economy has slowed over the last few quarters and growth will likely be weak for the next few quarters as well, in our opinion, there is far less justification for further rate cuts at this time. While everyone would like to see the economy grow, such growth would be fruitless if it comes paired with rising inflation.

The declining dollar and record-setting commodity price inflation are already putting stress on the economy; a further decline in the value of the dollar could present far greater problems than slightly lower rates might solve. The price index for personal consumption expenditures—the Fed’s preferred inflation measure—has already risen above 3%–setting off inflation warning bells.

We think that the Fed is in the midst of an interesting balancing act between weak growth and inflation concerns. Although the statement released by the Fed does not inspire a whole lot of confidence for the near term, it was the correct action (or lack thereof) at this time.

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  •  
    BxCapricorn
    Jun 25 07:49 PM
    Remember a few weeks ago when Bernanke was speaking to a group of Harvard graduates. His main point of that speech was that we are no longer in the 1970's, where price inflation was responded to with wage inflation, and a spiraling situation was created, as one made the previous action worse.

    Well, we're not in the 1970's because....we no longer have unions or organized labor that can force increases in wage, so price inflation is not chased higher. The Fed believes that we as consumers will respond to price increases by simply avoiding the costs as much as possible. Decreased demand will thus counter inflation and the price will come down. You're going to hear "demand destruction" so many times over the next several months, that it will actually make you slightly ill. The Feds, in their obvious condition of being boxed in and helpless to counter inflation through a rate hike, lest the financial system implode, has adopted a strange, never-before-used or validated, permutation of the Phillips Curve.

    The Chairman's own words, on June 9th.
    www.federalreserve.gov...

    More than you ever wanted to know about "The Phillips Curve", from the Federal Reserve Bank of Minneapolis, in PDF form.
    www.minneapolisfed.org...

    If you read the last linked bit of information, the final paragraph and conclusion are stunning.

    "We conclude from this historical record that the Phillips curve–based model which helps the staff at the Federal Reserve Board forecast—just like other Phillips curve–based models—has not proved to be useful for forecasting inflation for the past 15 years."

    They then conclude that....

    "Phillips curves of various kinds have been a major component of many macroeconomic models for the past 40 years. Economists such as Blinder (1997) argue that Phillips curves should continue to play such a role because these curves summarize empirical relationships critical for policymaking. Our review of the evidence indicates that this view is mistaken. We find that for the last 15 years, economists have not produced a version of the Phillips curve that makes more accurate inflation forecasts than those from a naive model that presumes inflation over the next four quarters will be equal to inflation over the last four quarters.

    Some might conclude from our review that applied economists should renew their search for a stable empirical relationship between unemployment and inflation that might be used to improve inflation forecasts.We conclude otherwise. Given the weak theoretical and empirical underpinnings of the various incarnations of the Phillips curve, we conclude that the search for yet another Phillips curve–based forecasting model should be abandoned."

    And yet, the Federal Reserve is currently using an untested permutation of a Phillips Curve, that was previously useless, as the guiding light towards getting our economy and markets stabilized?

    Here's PIMCO's Managing Director Paul MccCulley, two weeks ago, being right on the money in his assessment of this tactic.
    www.cnbc.com/id/250948...

    So, to summarize. Inflation will solve itself because consumer purchasing power will be so damaged that "demand destruction" will take place, curbing prices. Even if you, as a consumer, could get a wage increase, the best you can get is a CPI-based adjustment, and that number has been handicapped to the low side. 70 plus million retiring baby boomers on fixed incomes, and they are all simply oblivious to what is coming down the pipe.
  •  
    TinyTim
    Jun 26 03:15 PM
    where the hell is Paul Volker?
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