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The Fed's quandary: Stimulate economy, but not inflation

Posted Jan 4th 2008 3:11PM by Joseph Lazzaro
Filed under: International markets, Forecasts, Other issues, Economic data, Federal Reserve

A housing sector that remains in correction mode, to put it diplomatically; a contracting manufacturing sector; declining auto sales; a pull-back in consumer spending; anemic job growth -- historically, these would signal a no-doubt-about-it easing monetary policy by the U.S. Federal Reserve to stimulate the economy.

But hold on, the nation's economic landscape is not that simple, as Fed Chairman Ben Bernanke would no doubt tell you.

Inflation, at both the consumer and producer levels, is rearing its ugly head. Fanned higher by the near-record price of crude oil, inflation is already above the Federal Reserve's target zone (also called the Fed's "comfort zone"), and is likely to move higher later this year if +$80 per barrel oil persists. (Oil fell $1.90 to $97.28 Friday afternoon on fears of a U.S. recession.)

Little leeway for Fed?

Economist David H. Wang told BloggingStocks Friday that the Fed's dilemma does not match its full-blown stagflation predicament of the mid-1970s / early-1980s, but navigating a correct monetary policy for the U.S. economy "will be a difficult task, maybe the toughest monetary problem the Fed has faced since the terrorist attack on September 11, 2001."

"Inflation is rising, and will continue to be a thorn in the economy's side so long as oil prices remain high, so the Fed has to be concerned about its effect on the economy. At the same time, we have anemic job growth -- the 18,000 jobs created in December is essentially 'zero job growth' -- and there's a danger the economy may begin to shed jobs in 2008," Wang said. "There's no easy monetary policy out of this."

But cut, the Fed must, Wang said. In his interpretation, future Fed interest rate cuts do carry the risk of pushing inflation to higher levels, but the alternative is far worse: a recession. The Fed has already cut the federal funds rate -- the interbank interest rate -- to 4.25%, and the discount rate -- the rate it charges banks for loans -- to 4.75%.

"The inflation risk is there, but the risk of a recession is greater and capable of doing far more damage to the economy," Wang said. "A contraction by the economy, with its job losses, would only magnify the downturn in housing and its likely defaults, and take many economic casualties with it."

Wang -- who sees the Fed cutting benchmark interest rates by 25 basis points at least two more times -- said the Fed "should have cut rates by 50 basis points at its last meeting" to feed stimulus into the economy that much quicker.

"One theory in economics argues that at the first definitive sign of a recession, interest rates should be cut a sizable amount. Then, if you later learn that the stimulus was too large, you can always re-raise rates," Wang said. "It provides lubricant at the first sign that the machine's gears are grinding. On the other hand, if you wait, it's very hard to stop a recession once conditions have deteriorated."

Fiscal stimulus

Economist Steve Affinito agreed with Wang, but argued that the contraction forces now acting on the economy are so large that fiscal stimulus also will be needed to keep the U.S. economy from falling into a recession in 2008.

"President Bush has already talked about a possible economic stimulus package. Well, it's needed, and fast. We need a good-sized tax cut and/or spending stimulus package to add demand and stimulate commercial activity in the economy, and the sooner we do it, the better," Affinito said. "It could be a combination of tax cuts for consumers and corporations, and additional spending on infrastructure and mortgage assistance, along with maybe an energy tax credit...all of the above would go a long way toward stimulating demand."

Regarding stimulating the economy, Affinito added that "the Fed can't do it alone," and that absent the fiscal stimulus, he put the chances of a recession at "70% likely in 2008."

Wang was more cautious on the risk of a recession in 2008, putting it at 50/50, but he was just as supportive of a fiscal stimulus package.

"Given the amount of activity that's being taken out of the economy by the housing sector's slump, it's not hard to argue for a $400-$500 billion stimulus package, maybe more, from tax cuts and new spending," Wang said, adding that he currently expects 2008 U.S. GDP of 1.0-1.5%.

"The U.S. economy with a growth rate of 1.5% is anemic growth, hardly what's necessary to create enough jobs to keep unemployment from rising and to maintain solid corporate profit levels," Wang said.

Affinito added that those hoping that a large decline in oil prices will provide a "de facto tax cut for consumers and businesses" should not place too much confidence in that possible outcome: oil prices have remained "remarkably resilient," he said, supported by solid global growth.

Global tailwind persists, so far

Further, that strong global economic growth provides all the more reason for both the Fed and fiscal policy makers to act jointly regarding economic stimulus, Wang said. That's because global growth has helped keep the U.S. economy afloat amid the domestic contraction forces of housing defaults and sluggish consumer spending, among other factors, he said. "If that global activity ever slowed, given the present condition of the U.S. economy, the U.S. economy would then fall into a major recession," Wang said.

"I think the onus is on policy makers to jump-start demand," Wang said. "Previously one could argue that demand would be present as long as the economy was creating a modest amount of jobs. But December's anemic new jobs total pretty much put an end to that argument."

Tags: Bernanke, Bush, CapitalSpending, consumer spending, corporate profits, CPI, featured, fiscal policy, gasoline, GDP, global economy, global growth, housing, inflation, job growth, jobs, monetary policy, oil, PPI, tax cut, U.S. Congress, U.S. economy, U.S. Federal Reserve, unemployment

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