Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.
The argument between the financial markets and the Federal Reserve continued unabated early this week, marked notably on the first full trading day past Thanksgiving with a decline in interest rates on the 10-year Treasury bond to 3.80! (not to mention another 200+ point decline in the Dow). The markets either simply didn’t believe the Fed that the risks to the economy from inflation and recession are evenly balanced at this point (and that the Fed therefore proposes to maintain “neutrality” in interest rate terms with no further cuts short of a catastrophic, present-tense market event) or simply disdn’t't believe IN the Fed anymore – even if it cuts rates again in two weeks, it will be too little, too late to stop a recession by 08!
Fed officials, including Chairman Bernanke, were scheduled to speak publicly this week — probably their last chance before their usual pre-meeting “blackout” period to reestablish a sense of connectedness to the reality which the markets see, and perhaps also to reiterate in the subtlest way their concerns about the effect of a depreciating dollar on their range of policy options.
As this blog has been noting all year, the Fed is caught in a dilemma: if it cuts rates to sustain economic activity, it invites a run on the dollar, higher oil and other inflationary pressures and expectations that would in turn call for rates increases. Well into the summer it sought to avoid this trap with a forecasting view that the sub prime/credit crisis was ring-fenced away from the economy at large: a sort of ‘studied complacency’ that only served to convince many market participants that the Reserve Board itself was out of touch with reality.
That studied complacency appeared again earlier this month in post-meeting commentary by several Fed officials and to a lesser degree in the Fed vaunted new forecasting models, whic; which edged down their collective assumptions for growth and inflation into the coming year, as well as the model target for ‘sustainable’ GDP growth going forward. A company which put out a similar growth forecast for the coming next couple of years would have had it shares pummeled in the unforgiving equity markets. For the Fed, the market’s only recourse was to test its lows and punch through them to an “official” 10% correction on Monday.
It’s not that the markets do not recognize the inflationary risk in a battered dollar attributable to lower interest rates. The market is simply saying, with Scarlett O’Hara, that “I’ll worry about that tomorrow!… Today I’m worried about foreclosures, the balance sheets (and lending capacity) of banks, the staying power of consumers, not to mention election year mischief.”
The markets had only one weapon against Fed determined to hold the line — a Scarlett O’Hara swoon! And apparently Scarlett got her man (or men), as in successive speeches on Wednesday morning and Thursday evening the Fed Vice Chair and Chair both acknowledged the markets’ view of reality — namely, that things had changed for the worse in terms of incoming data since the Fed’s last pronouncement about evenly balanced risks of inflation and recession, and that the Fed would have to respond with “nimble” and flexible policy (translation — a December interest rate cut is on the table).
So it appears that the Fed will not let Scarlett go hungry this Christmas, anyway.