What's the Price of Inaction?

It's been all about prices lately, and it'll continue to be about prices for some time.

The update du jour on that front is import prices, which, according to the Bureau of Labor Statistics have surged higher by nearly 18% for the year through May. On a monthly basis, the trend looks a bit less threatening. Import prices rose by 2.3% last month, down a bit from April's 2.4%. The trend looks even better if we exclude prices of petroleum imports, which continue to climb into uncharted territory. Even so, non-petroleum import prices are up 6.6% for the year through May, reminding that the U.S. continues to import inflation.

For comparison, domestic inflation is up by a relatively mild 3.9% for the 12 months through April, with an update for May scheduled for release tomorrow. It doesn't take a lot of math to figure out that the more this country imports, there will be increased pressure for higher prices in everything from onions, to oil.

Any way you slice it, prices generally are rising. To date, the Federal Reserve's position has been more or less to hope that the slowing economy would take the edge off the pricing pressure. As we've long argued, that's an especially risky policy for this economic cycle. Much has changed in 2008 compared to recessions past, and so waiting for aid in the form of slowing or slumping demand may not do the trick this time around.

For starters, the central bank started cutting rates much earlier in this cycle compared to the past. Pre-emption has its merits, given the challenges swirling about, but it's not a free lunch. However, that's history. The immediate question is what to do now in terms of monetary policy?

Waiting and hoping looks increasingly dangerous if only because it's proven ineffective so far. For some time now, there's been talk that oil prices can't go any higher, that global demand for energy will slump, and that the inflationary pressures will soon subside and effectively do the central bank's job. In short, there's no need to raise interest rates because the inflation jump is a temporary glitch that would soon be corrected by macroeconomic forces.

For all we know, the correction may commence any minute. Then again, maybe relief isn't coming at all, in which case the U.S. economy becomes ever more vulnerable to inflation the longer the Fed sits on its hands. Moreover, as history teaches, once inflation takes root in the economy and the minds of consumers, the central bank's job is much, much tougher.

For the moment, the market expects no immediate changes in monetary policy, with gradual interest rate hikes coming later in the year. The November '08 Fed funds futures contract, for instance, is currently priced in anticipation of a 50-basis point hike to 2.5%.

There is no doubt the Fed is in a tough spot. This is an election year, and no one wants to be seen raising interest rates at a time when the voters are paying more for almost everything these days. Then again, there's a reason the Fed was set up as an independent institution that's relatively immune from the immediate passions of the political realm. Central banks weren't invented to make voters happy. In fact, one could say that an unpopular central bank may be a central bank that's doing its job, which in this editor's opinion is maintaining the integrity and value of the currency. After all, if the Fed falls short on that front, can it really be effective in any other sphere?

Granted, the surge in prices is driven by supply problems these days. Nonetheless, demand isn't irrelevant. Yes, higher prices are starting to do some of the work in terms of cutting demand. For instance, Americans are driving less these days thanks to the rise in gasoline prices.

Perhaps it all boils down to this: will the Fed help in the business of demand destruction via rate hikes? So far, the answer has been a clear "no." Of course, we'd all like to avoid recession. However, if that in fact is the only goal, one might ask: what's the price?

Comments

[John Pseudonym:]

If the Fed raises rates, they will spur more foreclosures.

They reason they are not acting is because they can't.

No matter what they do, there is a serious negative consequence to some major aspect of economy.

The Fed is frozen with fear!

2008 Jun 12 12:30 PM

[moonbat1775:]

If only it would freeze to death!

2008 Jun 12 03:01 PM

[pierre66:]

It seems the Fed has a true Hobson's choice - raise rates and watch housing continue down (along with our financial system and economy), or keep rates where they are and HOPE housing recovers while inflation gets out of control......Glad I am an investor with the ability to exercise wealth preservation mode rather than a central banker!

2008 Jun 12 07:20 PM

[bearfund:]

Nothing new here; the most the Fed will do any time soon is raise rates 25bp which is a drop in the bucket relative to the gulf between short rates and true price inflation. Recall that expectations are running north of 7%. Rates would have to rise hundreds of basis points in a matter of a few months to make a major dent in those expectations, and the collateral damage associated with that puts it out of the question.

Everyone knows how to make money in these circumstances: long gold, short bonds. Extend both positions after any "shock and awe" intervention or policy move; prices will be attractive - gold looks especially fragile right now and could be had for cheap if real action is taken - and the fundamentals won't have changed a whit. Meanwhile the bond vigilantes may have been unfrozen from their time capsule and appear to be doing the Fed's job for it by raising rates almost 25bp in a single day.

2008 Jun 13 12:35 AM

[cynic69:]

If helicoptor Ben raises rates the market will tank for sure. Dubya would then put out a contract on the guy. I think Ben should have stayed in classroom. Just think, he could be ogleing the coeds instead of worring about having his head handed to him.

2008 Jun 13 11:01 AM

[moonbat1775:]

Poor Ben, this poem for him

All the power and all the glory
but also, all the blame and all the shame.
But for us, just economic pain!
(Oh, and also, social unrest, revolution, World War III, etc.)

2008 Jun 13 02:14 PM