Does the Federal Reserve See Stagflation in Our Future?

Just about everyone on Wall Street expects the Fed to lower interest rates by a half point at its January 29-30,2008 meeting. Many on the Street are clamoring for a larger cut. What’s interesting is that today, Chairman Ben Bernanke announced, in testimony before Congress, his support for fiscal measures to stimulate the economy. Basically, that means taking a bunch of money from the U.S. Treasury (in the range of $75 to $100 billion, perhaps) and throwing it at taxpayers.

We like a check from the Treasury as much as anyone, especially if it comes with no strings attached and encouragement to spend. But it’s peculiar that the Fed Chairman, who is the czar of monetary policy, would propose a fiscal measure. Fiscal measures can only be taken by Congress and the President.

Ben Bernanke has the misfortune not to be what Alan Greenspan was: lucky. Greenspan benefited from the defeat of Communism, which greatly reduced the federal government’s defense spending and freed up a lot of resources for private investment. Worker productivity rose sharply during the 1990s, which allowed the Fed to get away with interest rate cuts without triggering high levels of inflation. Further, the derivatives market worked reasonably well during most of Greenspan’s tenure, transferring risk to parties willing to bear it without fostering undue levels of risk.

Bernanke has not done as well with his rolls of the dice. Defense spending has risen again with the wars in Iraq and Afghanistan. Income taxes were cut, so the federal deficit has ballooned. Productivity growth is no longer bounding upwards by leaps and bounds. The derivatives market, especially the mortgage-related portion, has created vast amounts of undue risk and losses. These risks and losses are buried in opaque, unregulated over-the-counter markets that are little understood; and they pop up unexpectedly to ambush banks and regulators.

Worst of all for Chairman Bernanke, inflation is on the rise. The CPI was 4.1% in 2007, and the core CPI (which excludes food and energy) was 2.4%. Both figures are too high for Fed comfort. What makes things worse is that real wages fell about 1% after inflation in 2007. By contrast, in 2006, real wages rose about 2% after inflation. Last year’s loss of worker buying power means lower consumer spending (which depressed the most recent Christmas shopping season). Expectations for continued higher levels of inflation mean that real wages may fall further. (With the economy slowing, employees aren’t in a position to demand higher wages, so their spending power will probably keep falling.)

If the Fed lowers interest rates, it may increase inflation. That, in turn, could further erode real wages. The economic downturn may grow worse as consumer demand falls, putting pressure on the Fed to further lower interest rates. However, more rate cuts would only exacerbate inflation, reduce real wages some more, and again depress economic growth.

Inflation by itself undermines economic confidence. But when inflation erodes real wages, causing economic weakness, we have stagflation, the economic malaise last seen in the 1970s. This is a particularly toxic predicament, because fixing stagflation requires sharp interest rate increases that foster a genuinely nasty recession (far worse than the current slowdown). That was the case in the early 1980s, when then Fed Chairman Paul Volcker wrung 13% annual inflation out of the U.S. economy at the cost of a recession that produced 10% unemployment. Volcker did the right thing. And in the finest Washington tradition of never allowing a good deed to go unpunished, his reputation has suffered ever since.

Bernanke now faces an incipient stagflation. He may be encouraging fiscal measures because he can’t lower interest rates as sharply as Wall Street would like, without setting off incendiary inflation. It seems possible that the market is starting figure that out, seeing as how the Dow dropped 306 points today.

When financial losses are as large as those of the subprime mortgage mess, there’s no easy, painless way out of it. If you’re hit by a car and suffer serious injuries, pain and a long recovery are inevitable. No amount of painkillers will change that; and too much painkiller will probably make things worse.

Retirement News: gaining weight doesn’t increase a pension. http://www.wtop.com/?nid=456&sid=1327882.