The US economy suffers both downturn and inflation. Emerging may take years; the US Federal Reserve must first discover what went wrong.
Fed chairman Ben Bernanke, in his testimony to the US Congress, said the Fed must remain “particularly alert” to any signs inflation is getting out of control. However, he said: “The possibility of higher energy prices, tighter credit conditions and a still-deeper decline in housing markets all represent significant downside risks to the outlook for growth.”
Three years ago the right Fed policy was obvious: Raise rates enough to produce a modestly positive real interest rate curve. That would have cooled the housing bubble and slowed the upsurge in commodity prices. That moment has passed. Inflation is here—the Producer Price Index, or PPI, rose 9.2% in the last 12 months. However, raising the Fed’s overnight rate target to double digits would devastate the US housing sector and the currently fragile financial system.
Retail sales rose 3% in the year to June. However, inflation was more than 4%. The housing downturn and financial tightening are hurting consumption. While exports will make up some of the slack, rising energy and commodity prices reduce the benefit.
The Fed is in a dilemma. Maintaining a 2% overnight rate, let alone cutting it, will increase energy and commodity prices, weaken the dollar and stimulate inflation generally. Conversely, raising interest rates sharply would further reduce housing “affordability” and intensifying recessionary forces.
The short-term solution is one of modest rate increases, strengthening the dollar and dampening commodity prices. Interest rates would remain well below general inflation, which will continue to accelerate.
Later, when stability has returned to the housing market and the financial sector, the Fed may have to undertake serious Paul Volcker-style rate increases, causing further recession but restoring the economy to stability.
The Fed must figure out what went wrong to correct matters, but will hope that nobody enlightens the public as to its massive role in the disaster.