The Fed isn't fooling anyone
The central bank's interest-rate cuts may be a quick fix for 2008, but they'll create a massive inflationary push in 2009, leading us right back into another boom-bust cycle.

By Jim Jubak
Do the members of the Federal Reserve think we're stupid? Do they think we don't understand that their quick fix for the economy and the financial markets in 2008 is going to completely unravel in 2009?

Do they think we can't see that they're setting up the economy and the financial markets for a replay of the bust-to-boom-to-bust cycle that followed the bursting of the stock market bubble in 2000, in which easy money created a housing bubble that has now burst?

The Fed's actions of the past five months are going to lead to higher inflation or higher interest rates (and a slowing economy again) in 2009. Apparently the Fed doesn't think we can read between the paragraphs of its Jan. 30 press release and see that coming.

Talk back: Where is the Federal Reserve taking the economy?

Here's what the central bank's Federal Open Market Committee said in that press release when it cut its short-term interest-rate target to 3% from 3.5%: "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in the labor markets."

That's a straightforward explanation for why the Fed decided to cut interest rates an additional half-point after cutting by three-quarters of a percentage point Jan. 22 -- a total cut of 1.25 points in roughly a week.

The economy is slowing, the Fed says, and banks and other sources of capital are still so nervous that they're making fewer loans. The housing market is getting worse, and so is the jobs picture. It looks like people who have lost their jobs are having trouble finding new ones. So to prevent a slowdown from turning into something worse -- such as a full-scale recession with a rise in loan and bond defaults from corporate borrowers that would panic the financial markets -- the Federal Reserve is aggressively cutting rates.

"Today's policy action," the Fed went on in the press release, "combined with those taken earlier, should help promote moderate growth over time and to mitigate the risks to economic activity."

It's the one-sentence paragraph before it that gets my goat: "The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully."

Policy might work in 2008
I understand why the Federal Reserve expects inflation to moderate in the next few quarters. If the U.S. economy is slowing in 2008, that's exactly what you'd expect in most situations.

Slower growth usually means less upward pressure on prices and wages because there's excess capacity at factories, more supply than demand for raw materials and more people looking for work. With gross domestic product for the fourth quarter of 2007 showing annualized growth of just 1.9%, it's reasonable to think that inflation might head down this year.

Reasonable -- but by no means certain. At the consumer level, headline inflation, which includes energy and food prices, hit a 17-year high in 2007 as the Consumer Price Index climbed 4.1%. That's way above the Fed's 2% inflation target. The core inflation rate, which excludes food and energy prices, climbed 2.4%, also above the Fed's target. So even if inflation moderates, the final result might still be above the Fed's comfort zone.

But here's why it might not moderate this year: Much of 2007's inflation is a result of soaring food and energy prices. Energy prices at the consumer level climbed 17% in 2007; food prices rose 4.9%. Inflation from these two sources isn't likely to go down if the U.S. economy slows because so much of the demand comes from fast-growing China, India and the Middle East. It would take a slowdown in those economies to cut price increases in the United States. So far, projected decreases in growth are less than 1 percentage point -- or none at all.

But that isn't my big gripe with the Federal Reserve's press release. Maybe the Fed will get the moderating inflation it's looking for in 2008 because we're in an economic slowdown. My gripe is about next year.

What about 2009?
If the Fed's policy of massive interest-rate cuts succeeds in reviving the economy around the end of the year, won't we also see a big increase in inflation? After all, the Fed has been pumping billions in short-term liquidity into the U.S. economy, and other institutions, such as the Federal Home Loan Banks, have been doing the same.

We've seen interest rates drop and drop again in 2007 and early 2008. I think we're likely to see more rate cuts in the next few months as the Federal Reserve tries to stabilize plunging home prices. William Gross, the fixed-income guru at Pimco, says the Fed might take short-term interest rates as low as 2.5% to drive long-term mortgage rates low enough to rescue home prices.

Doesn't all of that -- higher economic growth, a flood of cash into the economy, slashes in interest rates -- create a massive inflationary push in 2009?

Absolutely, unless the Federal Reserve is counting on a global collapse in oil prices or economic growth to reduce global energy inflation and global demand for food and raw materials. But frankly, it's hard to see oil prices falling or the global economy stumbling if the Federal Reserve is able to reverse the decline in U.S. economic growth.

Fed has a bad track record
So, in 2009, we face a big problem and a difficult choice. We can ignore rising inflation because the U.S. economic recovery is still fragile, which risks letting inflation build momentum and makes it harder to fight in the future. Or we can raise interest rates to fight inflation and risk stalling the U.S. economic recovery.

The Fed doesn't have a great track record at that kind of decision. In the aftermath of the stock market bubble in 2000, Alan Greenspan's Federal Reserve took interest rates down to 1% to stabilize the financial markets and the economy. But then it left interest rates too low for too long, and that created the housing-market bubble. Will the Bernanke Fed do any better at handling the very tricky turn from an easy-money policy that supports the economy to a monetary tightening that prevents higher inflation and a new asset-market bubble?

I doubt it. But that's the huge challenge that lies just ahead for the Federal Reserve. Hand waving over how inflation will moderate in the coming quarters won't make it go away as the problems of 2009 loom. And such hand waving really doesn't fool anybody who has been paying attention through the past decade as the Federal Reserve has bounced from fixing one bubble to inflating the next.

Here they go again.

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