Tuesday, June 17, 2008
Will the real Fed please stand up!
|The Fed is in a “pickle”. In its upcoming June 27-28 meeting it will have to decide which battle to fight first: the soaring inflation or the slump in economic activity. Unfortunately, the wiggle-room for maneuvering is particularly tight. Much like Eminem’s alter ego Slim Shady (earlier in the decade), high oil prices “are back” and this time, with a vengeance. The Fed cannot take on both villains simultaneously: it needs to pick its spot, fight one battle at a time and tackle the remaining issue sequentially. Strategically, this is tantamount to playing the Lakers early in the millennium and deciding whether you should contain Shaq or Kobe since you can’t do both (as a Spurs fan, that analogy cuts me to the quick but it seemed particularly fitting here).
The question then, is: which fight should the Fed take on? In my opinion, the Fed will be less effective in combating inflation and should concentrate on jump-staring the economy. Here is why:
• Although inflation is on the rise, wages have remained subdued and at 2.3 percent, core inflation is only a tad above a year ago.
• Domestic and global economic slowdown will continue to put downward pressure on prices, thus partially self-correcting the inflation problem.
• For the first time, America is importing inflation: high commodity and food prices are largely due to high demand from emerging economies.
• Thanks to large budget surpluses, emerging markets have ample room to subsidize oil prices which means that not all countries are paying the same price at the pump.
• The Fed can coordinate policy with emerging countries so that their governments take steps towards reigning in high levels of inflation.
• More importantly, the Fed can anchor inflation expectations without having to raise interest rates by issuing statements which reiterate its commitment to fight inflation.
It remains to be seen what the Fed will do. I can only hope that it does not reverse its recent rate cuts too soon since that would be disastrous for the economy. Besides, swinging the interest rate pendulum from one extreme end to the other can be rather confusing, at which point, we will all have to demand for the real Fed to stand up!!