Obstacles On the Road to Reflation

The Federal Reserve is clearly attempting to lead a reflation effort, but it faces some serious obstacles. First among them is the impaired condition of the credit and securitization markets. The Fed's actions have little effect on the solvency of mortgage loans and securitized debt, and until banks have a clearer idea of the magnitude and location of the losses, there will be a natural reluctance to lend.

Second, as was demonstrated last week, the Fed only directly controls the overnight lending rate among banks. It has virtually no control over the market-determined interest rates that borrowers actually face. This can be seen in the spreads that have opened up between the fed funds rate and longer-maturity interbank rates such as 3-month LIBOR. It can also be seen in the longer-term interest rates that are most relevant to mortgage lending. Last week, for example, despite the Fed's rate cut, Freddie Mac (FRE) posted 30-year fixed mortgage rates jumped 15 basis points to 6.11%.

The reason for the rise in long-term interest rates last week was the ugly inflation data for November that was reported on Thursday and Friday. The Producer Price Index registered its largest increase since 1981, increasing 7.2% on a year over year basis. The Consumer Price Index was up 4.3% year-over-year. As evidence of the inflationary effects of a weak dollar, Import Prices were up 11.4% in November from a year earlier, the largest annual increase since this index was first published in 1982.

The inflation data highlight the awkward position and credibility problem of the Federal Reserve. Many on Wall Street have been clamoring for more aggressive rate cuts to bail out the dysfunctional securitization markets, but the inflation backdrop may limit the Fed's capacity to deliver more aggressive easing, at least in the near term.

Ultimately, the Fed will choose inflation in its efforts to mitigate the effects of the housing recession and credit contraction on the overall economy. Whether they succeed in this endeavor, and at what cost in terms of inflation, remains to be seen.