The Economy Now Enters the Political Dead Zone

The economy is wobbling, the credit crunch has abated but only slightly, housing prices continue to drop, and consumer spending is now caught in a chill north wind. However, there will be essentially no more meaningful governmental action between now and the Presidential election this November.

The Presidential contest is now in full swing. Congress has no incentive to do anything that might make the Republican administration look good, and the administration has no incentive to do anything that might make the Democratically controlled Congress look good. As a practical matter, there is scarcely enough time to engage in the usual sparring, negotiating and maneuvering that precedes any successful legislation. The tax rebates are an example of unusually quick legislation and it took a number of weeks to put together the tax rebate bill that made it through Congress and was signed by the President. Then, the IRS needed more weeks to do the computer programming and administrative work necessary to get the checks rolling out the door. That was a simple bill. Anything further the government might do (such as mortgage relief), would be far too complex to finish by November.

As we all know, when Presidential elections are concerned, it's the economy. Since we know that we're not stupid. The question remains, however, what could the meaning of "it" be?

Economic Stagnation. Whether or not we're in a recession is a semantic question that has little real significance any more. The economy is slowing down, people are losing jobs, middle class incomes are on a slippery slope, and expectations are low. The Fed's interest rate cuts over the last eight months may prevent the economy from shrinking. But they won't undo the malaise that is sinking into the electorate's psyche.

Housing Slump. Hundreds of thousands of adjustable rate mortgages are resetting this year, and that means many more defaults. Add in the job losses from the slowing economy, and the number of foreclosures this year will probably continue at a seriously elevated pace. Home prices are expected to fall. Nothing the federal government is now doing will significantly change the outlook for this year.

Credit Crunch. Chairman Bernanke and Secretary Paulson have recently said that the credit crunch shows signs of easing. But Bernanke also cautioned that things are far from normal. Add in the problems that consumers are now confronting, with home equity lines of credit being shut down and credit card terms tightening up, and you have what may be a growing problem. Even if the major financial institutions are a little farther from collapse than they were a couple of months ago, the paucity of credit will remain for at least the remainder of the year. If things start heading south again, expect the Fed to lower interest rates more. But it's getting very low on ammo. The fed funds rate is targeted at 2% now, and the Fed can't lower it much more. Besides, a rate cut now would be unlikely to have any effect on the overall economy before the election. If a major financial institution does a Bear Stearns, the Fed can take some billions of that institution's losses onto its balance sheet and save the day (at least for a few days). But the credit crunch will largely have to unwind on its own.

Inflation. Here's the real kicker. If the Fed's actions during the last eight months are successful, the economy will keep growing. But the Fed has been counting on an economic slowdown to combat inflation. It can't have it both ways--either there is a recession which restrains inflation, or there isn't a recession and inflation flares up. To make things worse, this isn't demand-pull inflation of the 1960's sort. We have heavy worldwide demand for commodities (like oil) and a great deal of speculative excess. Every time some teenage rebels in Nigeria fire a couple of RPGs, oil prices jump another dollar a barrel. You have to wonder if the Nigerian rebels hold the long side of petroleum futures contracts.

Inflation is the Democrats greatest economic talking point this election season. Unlike the housing crisis or job losses, inflation affects everyone every day and just about everywhere. You drive down the street and see gas prices higher than yesterday. You go to the grocery store and bread and milk have gone up again. You need a vacation, but the cost of commuting has eaten up your travel budget. Inflation gives every voter a reason to be discontent.

Congress is making a lot of noise about the Strategic Petroleum Reserve. Many members want the administration to stop buying oil to fill it up. Some members want oil released from the Strategic Petroleum Reserve, to knock down spot prices in the wholesale markets. The administration is adamant about filling the reserve, even though it's already 97% full, and is even more adamant about not releasing oil in order to knock down prices. Well, it's May and the Presidential election is still six months away. Here's our prediction. If, in October of this year, oil prices are still in the 120s or higher, and John McCain is in a tight battle, expect the administration to release some oil from the Strategic Petroleum Reserve. The Reserve is too small to have any lasting impact on oil prices. But it could have a short term impact on spot prices. A carefully timed strategy of releases could force highly leveraged speculators (and just about all commodities speculators are highly leveraged) to sell off their positions before they get margin calls. This will cause wholesale prices to crumble. Retail prices will follow soon thereafter (you can bet the major oil companies will lower prices at their stations because the last thing they want is some excess profits taxing Democrat in the White House). So, who knows? Maybe there will be some relief on the inflation front.