When Fed Chairman Ben S. Bernanke addresses the Kansas City Fed's annual economic symposium in Jackson Hole, Wyoming, today (Friday), he’ll have to acknowledge that the risks to U.S. economic growth have increased – especially with the disruption to the credit markets and the tightening of credit in many areas. But Bernanke will also likely be emphasizing that inflation – while showing many encouraging signs of being weakened – hasn’t been totally conquered, yet, either.
The Fed chairman finds himself in a very tough spot. If you’ve been reading the business pages of your favorite newspaper, visiting the financial sites online, or even watching the cable TV finance programs, you know by now that many of the most-vocal top executives from interest-sensitive sectors are clamoring for the U.S. Federal Reserve to cut interest rates.
But as I’ve been saying for months now, it’s very important for the central bank to move cautiously, and to maintain an unemotional, objective view that corresponds to actual developments in the real economy. Bernanke and the Fed absolutely cannot give in.
And many agree with me.
Indeed, top executives from soundly run banking institutions like Wilmington Trust (WT) are confident about the strength of the economic activity that they are seeing in their areas right now. They also do not see the need for lower rates right now. After all, folks such as Wilmington Trust didn’t indulge in same excesses as some of their less cautious counterparts.
What we don’t need is a repeat of 1998, when the Fed essentially fueled both the dot-com bubble and an unsustainable rate of growth for the U.S. economy, when it slashed interest rates to stave off the effects of the Long-Term Capital Management hedge fund implosion, the Asian Contagion and the Russian market collapse.
Nor do we need a repeat of the speculative housing bubble that stemmed from the record series of interest-rate reductions that the Fed engineered from 2002-2003. During that sad episode, speculators were able to capitalize on the availability of cheap, easy and innovative credit to buy houses they could then “flip” for a quick profit. That might happen several times with the same house before it was ultimately purchased for occupancy. The upshot: Many consumers ended up buying houses that were out of their price range and that they could not afford, because that’s all that was available in the marketplace.
In essence, speculators were “front-running” the ultimate buyers who wanted to actually own and occupy the home. But unlike other areas of finance, this type of “front-running” was perfectly legal. It was made possible by such innovative developments as interest-only loans, or loans with negative amortization – in short, many off the types of loans that are creating the current credit problems out in the marketplace. What’s more, in many cases these loans were used to buy houses where the speculators’ entire profit case was the so-called “Greater Fool” Theory: In short, the speculators worried very little about the “innate” value of the house they were buying, so long as they could be reasonably sure it would sell to someone else at an even-higher price.
Now, the “Greatest Fools” – the most-recent buyers – are stuck, if they are forced to sell immediately. This baseless-buying drove prices of homes in the speculative areas way above fundamentals, creating notable bubbles, which are now being quickly deflated. Such mis-pricing in these speculative areas is very negative to the economy, since it represents a real mis-allocation of capital – and since it also has inflationary implications.
Note that where home buying was based on traditional financing, prices have not declined significantly. In other words, where homes were financed with so-called “conforming” mortgages – or mortgages that didn’t exceed the $417,000 maximum that government-sponsored entities like Fannie Mae (FNM) could guarantee – prices have not declined significantly, recently. That’s because the irrational speculation in those geographic regions is very small, since so few homes were financed with the “jumbo” loans that carried the adjustable rates and low – or no – down payments. There just wasn’t a lot to “irrationally speculate” about.
But in his address to the Kansas City Fed folks in Jackson today, Bernanke will be speaking right after having the benefit of seeing the Fed’s preferred inflation gauge, the core PCE deflator, that comes out at 8:30 a.m. This will likely show a continuation of the gradual weakening of this inflation measure, which will probably come out at 1.8% or 1.7% for the last 12 months, still too close to the upper end of the Fed’s “comfort range” of 1% to 2%. Bernanke should also note that the central bank is very closely monitoring any market dislocations, and that the Fed stands ready to keep ensuring liquidity – just as the Fed has successfully accomplished in the credit markets recently, in joint coordination with the European Central Bank.
It’s very important that Bernanke buy some time in order to get additional confirmation in the economic data that growth and more importantly, inflationary pressures, are indeed abating and that inflationary expectations are very low before he reduces rates. This might not happen until after the next Fed policymakers meeting, on Sept. 18.
You see, as it looks right now, the economic indicators just don’t show the kind of slowdown that would warrant an interest-rate cut. Here’s why: Economic growth is still strong.
- Yesterday’s increase in initial unemployment claims is still far too small to warrant alarm.
- There’s been no meaningful decline in production activity.
- Consumer and producer prices haven’t shown any meaningful drops, yet.
- And prices of homes with conforming mortgages were up 3.2% from last year.
Keep in mind that making monetary policy is part art/part science, and because monetary policy works with lags, the Fed will no doubt reduce rates before seeing inflation at low or negative levels and before sending the economy into recession, but we don’t seem to be there yet.
The bottom line is this – and it’s one that’s most important to note: There’s a large speculative bubble blatantly evident in high-dollar (non-conforming mortgage) homes that is being rapidly deflated, while the rest of the U.S. economy is still growing in a healthy manner. Inflation is still abating, albeit gradually, and isn’t beaten, yet.
Since we don’t want a repeat of 1998, the Fed needs to refrain from over-reacting to the speculators’ despair and just continue its current strategy of making sure there is adequate liquidity in the credit markets – while the markets gradually sort out their speculative-credit losses and work their way back to their normal function. By staying strong, and showing resolve here, the Bernanke Fed will cement strong, non-inflationary growth in the U.S. economy for years to come.
Related News and Story Links:
- Money Morning Investment Analysis: The Fed Has Learned Balance as it Aids Market Recovery.
- Money Morning Market Commentary: Manage Your Risk and Boost Your Profits, Even in a Volatile Market.
- Money Morning News Report: Low Consumer Confidence Unlikely to Motivate Fed; Stocks Plunge.
- Wikipedia: Long-Term Capital Management.