TBO.com - TBO is Tampa Bay Online

The Market's Not Buying Into Federal Reserve's 'Inflation Problem'

ADVERTISEMENT

By CAROLINE BAUM, Bloomberg News

Published: January 8, 2008

Every time a piece of weak economic news coincides with a new high in oil and gold prices, we read the next day the Federal Reserve has an "inflation problem," limiting its option of lowering interest rates to resuscitate the economy.

As you work your way through your local newspaper, the next story to catch your eye may be one on the sorry state of the residential real estate market.

Most likely this article will start with an anecdote about Ma and Pa Kettle getting fleeced by their mortgage lender and losing their home through foreclosure. It will feature a lot of unsavory characters in Irvine, Calif. - "ground zero" for the subprime lending fandango - as well as facts and figures on the decline in house prices in your community, the rise in the number of homes for sale and the losses financial institutions are reporting as a result.

The two stories and two phenomena - falling home prices, rising goods and services prices - are not mutually exclusive. Nor are they likely to coexist for very long.

"Deflation in asset prices produces losses for lenders, who react by scaling back new lending," said Paul Kasriel, chief economist at the Northern Trust Corp.

Lenders do this for two reasons, he said. "One, they tend to close the barn door after the horse is already out. And two, banks take hits to their capital, so they can't afford to make new loans."

In recent months, banks such as Citigroup, Barclays and UBS have had to look overseas for capital infusions, raising a total of $35.6 billion, most of it from Asia and the Middle East.

The slowdown in credit growth will dampen economic activity, reducing demand for goods and services and exerting downward pressure on prices and incomes.

"Nominal income slows, yet fixed-rate debt doesn't change, so the payment becomes more onerous," Kasriel says.

Florida's Housing Issues Ripple

U.S. home prices are falling on a national average basis for the first time since the Great Depression. The rate of decline varies across the country, with once-hot markets (Florida, Southern California, Las Vegas, Phoenix) turning cold faster than others. More than 100 mortgage lenders have gone under. Banks are stuck with billions of dollars in bad loans. Investors who bought securities collateralized with pools of subprime loans don't know what their holdings are worth. And the market for that debt has virtually dried up.

With the tremors from the residential real estate market working their way first through the financial system and then into other areas of the economy, the Fed's "inflation problem" won't exist for very long. Something has to give.

"Japan is a perfect example of what asset price deflation can do for you," Kasriel says.

For the past decade, consumer prices in Japan have fallen at an average rate of 0.2 percent. Rock-bottom interest rates - the Bank of Japan's benchmark rate has been below 1 percent for 12 years - have done nothing to alleviate the modest deflation, or decline in the price level.

Hard to believe, but Japan's double asset bubble - in real estate and stock prices - burst in 1989. And it still can't dig out from under.

The slowdown in economic growth and inflation isn't necessarily contemporaneous. Inflation is a lagging indicator, generally peaking after the economy enters recession, Kasriel said.

A fire can't burn without tinder, and inflation can't smolder when the Fed is creating the raw material at a snail's pace. The monetary base, which consists of bank reserves and currency, is growing at an anemic 1.1 percent rate. In inflation-adjusted terms, the base is contracting.

Odds Stack Up For Rate Cut

All the talk about the Fed's inflation problem doesn't seem to have registered with the market where expectations are weighed.

The spread between nominal and inflation-indexed bonds, a proxy for expected inflation, has been falling.

The yield on the 10-year inflation-indexed Treasury fell to 1.54 percent last week. A year ago, the yield was 2.4 percent.

This is a real yield. The holder is compensated separately for inflation. "Real rates fall when activity is weak," Kasriel said.

The fed funds futures market, another forum for voicing expectations about Fed policy, is fully priced for another rate cut Jan. 30. The only question is whether it will be 25 or 50 basis points.

After Friday's weak employment report for December, with the first decline in private payrolls in 4 1/2 years and a 0.3 percentage point rise in the unemployment rate to 5 percent, the odds of a 50-basis-point cut to 3.5 percent stood at 60 percent.

The mantra that the Fed can't ease up because of inflation has been with us since before the central bank began to assuage the financial system stress in August, starting with a cut in the discount rate. Even when the source is the policy-makers, the market turns a deaf ear - and for good reason.

"Forced to choose between the integrity of the financial system and labor market on the one hand and price stability on the other, most central banks err of the side of the financial system and labor market," said Neal Soss, chief economist at Credit Suisse Group.

The Fed isn't about to break that pattern this time.

Share this:

Loading Comments...

Email Print

ADVERTISEMENT