Market Mover: Dealing With Higher US Inflation
Geithner Drops a Hint, Bernanke follows with a bomb
By blackhedd Posted in Bernanke | Economy | federal reserve | geithner | inflation | Interest rates — Comments (9) / Email this page » / Leave a comment »
A funny thing happened this morning as I was writing a story for you about Timothy Geithner’s important speech yesterday at the New York Economic Club: Inflation came back.
Geithner is the President of the New York Federal Reserve Bank, and his main topic yesterday was the gap between today’s innovative financial-market practices and the regulatory apparatus (including the Fed) that is supposed to keep markets stable.
This is a critical topic of great interest to policymakers around the world, and a consensus is growing that a “unified global framework” for financial regulation is needed. I’ll write a complete post about this subject later on.
But in the Q/A after his speech, President Geithner was asked (inevitably) about where the economy is going. He said that demand is getting softer, but he also said that the Fed will be watching inflation very carefully.
Federal Reserve officials always tread a very fine line in public statements because they know everyone will parse every comma for signals about the direction of interest rates. By emphasizing inflation over economic slowness, Geithner left an impression that they might head higher.
Keep reading…
As I’ve told you, the Europeans already signaled higher interest rates last week. Elliptical remarks by European Central Bank Governor Jean-Claude Trichet on Thursday were the trigger for a big wave of dollar-selling and crude-oil buying. This was why oil prices hit $139 on Friday.
So what happened next was that Fed Chairman Bernanke piled on last night with a statement that he sees considerably less risk of an economic slowdown, but will aggressively meet any signs of increasing inflation in the US.
The whole time that Bernanke and his colleagues have been slashing policy interest rates since last September, they’ve always been very clear that they would reverse quickly if they caught the smell of inflation. Most of us expected rates to stay steady for the rest of this year. So if there is an early change to tighter monetary policy, it’s a surprise.
Markets have reacted strongly to this decided shift in the regulatory tone. Bond markets are steeply lower this morning, the dollar has rallied against both the yen and the euro (up from 1.57 to 1.55), and crude oil continues its retreat, trading this morning around $134.40.
What’s missing from the picture is any clarity on whether the Fed’s economy-watchers are actually seeing a return to stronger conditions. The other possibility is that they’re trying to walk back some of the inflationary impact of the extraordinary actions they took in the wake of the Bear Stearns collapse and the severe money-market disruptions that occurred in March and April. This is a question I’d ask Bernanke and Geithner if given the chance.
If we start moving to higher interest rates while the economy is still weak, it could prolong the weakness. But as I’ve said many times, this recession is different because it’s being driven primarily by weak credit formation. If we can address this problem (which actually is tied in deeply with the housing markets), then economic conditions should improve.
Watch this space. I’ll update the story as needed.
Oh, and as an aside: Here's a question that I don't see anyone in Congress asking: why is it that prices of crude oil have become so dependent on monetary policy and financial markets? Oil is supposed to be an industrial commodity, not a financial instrument, right? Well, no, that's obviously not all it is. We do a lot of bloviating about drilling ANWR and building more refineries (and Barack Obama keeps chattering like a wind-up doll about windfall profits taxes), but the influences on oil prices are far more complex than many people appreciate. And therefore, their political impact is too.
-Francis Cianfrocca (“blackhedd”)
"That Was an Extraordinary Thing To Do" — Comments (4) »
Market Mover: Dealing With Higher US Inflation 9 Comments (0 topical, 9 editorial, 0 hidden) Post a comment »
I am not a big fan of aggressive moves by the Fed in either direction. A casual review of the history will show that they more often do harm than good.
Slow, steady growth in the money supply, very modest changes in interest rates, these are OK, but too much movement, too fast, has nearly always resulted in havoc.
"Nothing works like freedom, Nothing succeeds like liberty"
Kyle
The federal funds rate is currently at 2%, you can't really take off more than 2% from 2%. Also, factor in inflation, and parties which pay only a limited markup over the fed rate are already borrowing for free. The banks themselves face a slightly negative interest rate...
Since negative interest rates have all sorts of adverse effects as well if they are maintained over a long while (for starters: we didn't get into this mess by people borrowing too little, did we?) I'd say that's reason enough in itself for the FED to have a long hard look at every opportunity to up the interest rates a bit.
That being said, we've been lower than 2% before (see http://www.federalreserve.gov/fomc/fundsrate.htm ) so I have to hedge a bit, but smart money seems to be betting on a rise somewhere this year.
BTW, you are right about the general point: if oil stays as tied to monetary policy as it is now, life gets a lot more complicated.
...to Chairman Bernanke. If you'd left out the word "recognized," I might have taken a shot at it :-)
The Fed measures inflation in terms of what they call a "core" rate that seeks primarily to discern signs of positive feedback between wages and consumer prices. They generally exclude oil prices from their measurements, but these days I think they have no choice but to look at them.
(The ECB is more old-fashioned than the Fed, and they measure inflation by monetary aggregates like M2 and M3. They've been inflation hawks for at least a year and a half now.)
More importantly, though, the Fed recognized from the beginning of the credit crisis that interest-rate changes were a crude and non-ideal tool. You reduce interest rates when you want to give bankers an incentive to take more risk in the real economy, but that wasn't the problem here. Rather, the problem was extreme technical stresses in the money markets themselves, including very poor liquidity.
Lower rates are a crude way of increasing liquidity but of course they also increase inflation, which was the risk the Fed has always acknowledged they were taking. The more creative tools they've invented more recently (including the TAF, the TSLF, and the opening of the discount window to non-bank institutions) are better-suited to the current set of problems.
That's a long-winded way of saying that the Fed probably never saw a need to go to the 1% interest rates of the 2003-04 period. So whether oil prices counteracted that move may not be that interesting a question.
Fed funds have been pretty well-behaved over the last month or so. This morning they're about 2.02%. From what I can see, we haven't had one of those wild days with a zero fed-funds rate since April.
Not sure how closely you follow money markets, but we had a few days back then when the overnight-repo rate on the three-month T-bill was literally negative. Every once in a blue moon that happens with Treasury bonds, but I don't think it's ever happened before with bills. I was scared.
The Fed is caught between a cost-push inflationary factor and a recessionary factor.
Inflation is being driven by soaring prices for commodities, including but not limited to oil. And recession is being driven by the collapse of the credit and housing markets. It's the Fed's misfortune to have to deal with both at the same time.
And as always with stagflation, Fed focusing on one may make the other worse.
The energy problem is a structural problem that has to be dealt with by other tools, and by the other branches of Government, not by the Fed.
...an economic problem. The inflation that the Fed is concerned about was generated by the Fed itself, as part of their effort to stem disorders in the money and credit markets.
Price inflation in commodities and products like gasoline is only partly a monetary phenomenon. The Fed will slam on the brakes if they see evidence that factor-price and consumer-price increases are being fed through into higher wages.
Unless that happens (and there's no evidence of it yet, with employment falling), then the higher prices will simply result in normal economic adjustments. (People will drive less and do more of other things, like rent movies at home.) Those aren't the kind of effects that require higher interest rates.
It would seem they can't slash rates as forcefully as they did in 2002-3 in this environment because the impact on oil prices intensifies the inflationary effect.