Monday, December 04, 2006

Reader comments and other rarities

One reader had the following to say about Friday's steepener post...

"When do the Fed's Governors quit talking up the inflation fears and finally talk about the weakening economy ..... when it's too late ? It seems as if they're putting themselves into a non-winning position by yelling "fire" so often "

Here is my thought. I'm assuming by "fire" the reader means warning about inflation. I think the Fed faces a real conundrum. There were two major "mistakes" in the Fed's history. One was in the 1930's, decreasing the money supply at a point where the economy was already weak, thus causing the Great Depression. The second was the 1970's stagflation, where the Fed allowed the money supply to grow to help economic growth while allowing inflation expectations to become entrenched at a high level.

Stagflation is a real risk here, and the Fed knows it. The bursting of the housing market bubble is (and will) weighing on the economy both because of job losses and consumer behavior. But the economy is still awash in liquidity owing to the 1% Fed Funds rate of 2003-2004. Inflation measures continue to creep up, the dollar is weakening, etc.

In order to avoid the mistakes of the 1970's, the Fed will continue to talk very tough about inflation. What they want to avoid more than anything else is a loss of credibility. If the public continues to believe that the Fed is still primarily concerned about inflation, and will do whatever it takes to avoid accelerating inflation. As long as this credibility remains, the Fed can afford to just leave rates where they are and allow a weaker economy to solve the inflation problem.

Once their credibility is lost, they become forced to embark on a 1980's style series of painful rate hikes. No one wants that. So even if they think there are serious risks to the economy, as long as the level of inflation remains elevated, they are going to continue to emphasize the inflation risk.