The Fed is Fighting a Two Front War

Includes: DIA, QQQ, SPY
by: Bruce Allen

It's a good thing that Adolph Hitler decided to invade the Soviet Union before disposing of the Brits, or we’d all be speaking German today.

He proved the old military adage that you can’t win a two front war. Which is exactly what the Federal Reserve is preparing to fight in the recessing summer of 2008.

London during The Blitz

London during The Blitz photo courtesy of

Since the fall of 2007, the Fed has been cutting interest rates in an effort to support an economy taking a beatdown from a combination of factors–the collapse of the mortgage and the housing markets, subprime fallout, hedge fund bailouts, the dollar and the stock market getting punished, ad nauseum.  Doing what it could to avoid an unavoidable recession born in the ashes of perhaps $2 trillion in lost home values, vanished in the subprime “pump and dump” scheme, itself a direct result of lax federal regulation.

As expected, the results of this work have been modest.  The recession is upon us.  Decades of easy money have eroded the value of the dollar and helped drive up the cost of commodities, notably food and energy.  Real interest rates are negative–2 1/2% discount rate, inflation of 4 or 5 %.  The negative trade balance, $700 billion a year and growing, shows us exporting economic growth and importing inflation.

Now, at the bottom of the rate cycle, the Fed finds itself needing to address oil-induced inflation by raising interest rates.  Rising rates will slow the economy.  Stagflation, such as is upon us today, forces the government to fight a two front war–inflation and recession.  Last time, the Fed Funds rate went to 14%, and we got the Recession of 1982, the largest since WWII.  Last time, we didn’t have a mortgage or housing crisis, either.

On Main Street, consumers at or below median incomes are looking at breathless newspaper headlines announcing inflation of 5%.  They’re giving up lots of stuff–discretionary driving, restaurant food, travel, big ticket items, houses and cars–trying to put food on the table and gas in their cars.  On Main Street, it feels more like 15%.  And it’s baked into the economy, in the form of global competition for food, energy and manufacturing resources.  Yet people are getting laid off.

You can’t win a two front war.  But here comes the Fed anyway,  preparing to launch an assault on the beaches of inflation.  They see General Motors raising prices in the face of steeply declining unit sales.  They see Dow Chemical raising prices by 20% and then 25% on top of that.  They see corn and oil futures near all time highs, and they see growing global demand.  They see a number of what they call “secular trends” at work driving demand across the globe.  They see China beginning to run out of drinking water, and they see Israel poised to take out Iran’s nuclear facilities.

Stagflation is a symptom of an economy in disequilibrium.  The recession and rising CPI and PPI numbers are directly related to the balance of trade.  A trade deficit of $700 billion amounts to exporting 5% of GDP.  The flood of dollars out of the country since 2003 has caused the buck to decline by around 30% against a basket of Western currencies.  It now trades evenly with the Loonie, for God’s sake.  In effect, 30% of the premium in oil prices is due to easy money and the resulting fall in the dollar.  In Euro countries, our $130 oil feels like $100 oil.

By raising rates, the Fed is willing to push the trade deficit up, as exports become relatively more expensive and imports cheaper.  The good news is that it will bolster the dollar and the bond markets.  Higher interest rates will put more pressure on the reeling housing and mortgage markets.  Higher rates will also add to job losses, but a recession won’t necessarily force food or fuel prices down, as world demand is growing faster than ours is likely to fall.  It was a domestic economy in the 1970s.  It’s a global economy today.

There appears to be a speculative bubble in oil, grain and metals markets.  The likelihood of its bursting in the foreseeable future does nothing to alter basic supply and demand dynamics.  Americans are modifying their behaviors, becoming almost, well, European, driving less and discussing energy prices and pollution issues.  This so-called “demand destruction” is likely to be temporary as people adjust to the new world energy order.

The administration and Congress arriving in Washington in January of 2009 are unlikely to stand idly by while the economy descends into a significant job-crushing recession.  They will apply fiscal stimulus, hundreds of billions of dollars of it, smoking the tires.  One foot on the gas and one on the brake.

In basic economic equilibrium, demand equals supply.  When demand exceeds supply and prices go up, an efficient market responds by increasing supply and/or reducing demand.  The Fed can’t grow more corn or pump more oil.  Raising interest rates dampens demand until the system returns to equilibrium, but it is painful medicine.  It’s the only medicine they’ve got these days.  It won’t slow inflation any time soon.  And it is friendly fire in a two front war.