This past week the news flow rekindled recession fears in the United States. Lehman Brothers came under a cloud again, the credit ratings of bond insurers Ambac and MBIA were downgraded, May unemployment showed a jump from 5% to 5.5%, and crude oil shot up to a record $139 a barrel.
The U.S. was headed for a recession in 2001 but Federal Reserve Chairman Alan Greenspan dodged it with a dramatic reduction in interest rates and the help of a bubble in real estate. My guess this time around is that current Fed Chairman, Ben Bernanke, is willing to allow more of a downturn to emerge.
One sign: Bernanke drained the liquidity created by his rescue of the U.S. financial system to keep high-powered money on an even keel. Another sign: his recent speech about the need to avoid further interest-rate decreases to keep the U.S. dollar from going into a tailspin and fueling inflationary pressures.
Then there is the greater inflation threat in 2008. Prices for commodities and agricultural products are soaring. The consumer price index may still be relatively well behaved but the person in the street is complaining about inflation feeling higher than reported, thanks largely to gasoline and food prices. And investors are less willing to hold bonds as demonstrated by the recent run-up in their yields. The last thing Bernanke wants to see is an inflation psychology take root, where people seek to recoup lost purchasing power through bargaining for higher wages and demanding higher bond yields.
Politically, the timing for a downturn is about the best one can hope for. It’s early in Bernanke’s term and the term of the next President. There will be plenty of time to turn things around and get the show back on the road over the course of their terms.