May 19, 2006
Inflation returned to the market's collective consciousness this week, as detailed in the April report on consumer prices. But yesterday came more signs that an economic slowdown may in the offing as well, by way of the Conference Board's index of leading indicators and a surge in jobless claims for last week.
Adding to the perception that a downshift in growth is taking root are fresh comments from Fed Chairman Ben Bernanke, who yesterday observed that the real estate market is cooling. "It looks to be a very orderly and moderate kind of cooling at this point," he explained via CNNMoney.com, but a cooling nonetheless.
It's no secret that some dismal scientists have been predicting a softening in the economy's momentum for the second half of this year and beyond. That view has been under pressure of late thanks to a string of economic reports that suggest the economy's still bubbling. But yesterday's numbers give a bit more credence to the forces of pessimism.
If a slowdown is coming, it may arrive just as inflationary pressures are gaining momentum. In that case, does that mean that stagflation is just around the corner?
The seeds of stagflation are excess liquidity conspiring with slower growth. In the worst cases of stagflation, inflation eats away at the value of paper assets while real growth trails the pace of value destruction.
Is stagflation upon us? No, not yet. Keep the fiend at bay will depend on how the Federal Reserve manages the money supply going forward. Make no mistake: finding the sweet spot between promoting growth and minimizing inflation will be difficult, and perhaps impossible. All the usual caveats apply in hoping otherwise, starting with the fact that central banking is a discipline where today's decisions influence outcomes a year or two on.
Long lag times are problematic under the best of times. Unfortunately, these aren't the best of times. In some respects, this particular juncture could scarcely be worse for the prospects of vaccinating the economy against an emerging virus of stagflation while at the same time keeping the economy afloat. The reason is that attacking each side of the stagflation threat requires different and contradictory policies. Alas, both sides of the stagflation threat require attention.
The prescriptions are, at least, clear cut. Fighting inflation is an assault of tightening monetary policy. At some point, squeezing the money supply spurs an economic slowdown or worse. Although robust growth and low inflation have defined much of economic history over the past generation, expecting more of the same as a natural and inevitable outcome may be asking too much of the future.
The Fed, after all, has had its share of struggles in favoring either controlling inflation or promoting growth. It may very well come to that choice in starker terms in the months and years ahead. It wouldn't be the first time. The Fed has faced that Hobson's choice more than a few times over the decades. Unfortunately, history doesn't offer much encouragement that the central bank is always up to the task of balancing this double-edge monetary sword.
On tightening too much and for too long, the infamous example is the early 1930s, when the Fed went off the deep end, with the tragic result known as the Great Depression.
On the opposite extreme is the case of the 1970s, when the Fed unwisely tried to use liquidity to promote growth. The result: high inflation that was only choked off when the fearless Paul Volcker snuffed out the fire in the early 1980s.
To be sure, the modern Fed isn't likely to repeat the mistakes of the past. Bernanke and company is a wise bunch that understands the limits and risks of central banking, in part because they've studied history. As such, any stagflation is likely to be of a milder form compared with decades past.
But intelligence only gets you so far in managing the money supply for the world's largest economy. The challenge is compounded by the fact that expectations for central banking success are sky high. Even a relative stumble by the Fed could trigger profound reactions in the bond and stock markets, i.e., heavy selling.
Monetary policy, we must all remember, is an inexact science. The idea that a cabal of men, sitting in an ornate room in Washington, can dictate the perfect level of interest rates at any given time, and dispense it in regular intervals is the stuff of dreams.
Yes, the Fed has done a masterful job of engineering a lower rate of inflation over the past generation. But how much of that was due to enlightened decisions and how much to disinflationary winds blowing through the global economy?
While we're asking questions, the more pressing one will be: Is the Fed prepared to navigate between the jagged rocks of inflation on one side of the economic channel and the dangers of recession on the other? What are the risks of failure?
For the moment, there are no answers. Bernanke is still an untested steward of the nation's money supply. Meanwhile, monetary policy going forward faces some of its biggest challenges in a generation.
Welcome to a period of transition. It's a long, drawn-out transition, and one with conflicting signals coming on any given day. But no one should ignore the fact that ours is an era of moving from the glories of the past to the hazards of the future. Perhaps the only thing an enlightened investor can do is ask if the various asset classes are accurately priced for the various risks that loom, and then act accordingly.
Posted by jp at May 19, 2006 9:26 AM
As someone said about the Supreme Court, "They count votes also". If the econ starts dragging significatly in the next couple of months, there will be impossible political pressure put on the Fed to push for expansion at the cost of inflation. Yes I know that what ever the Fed does in a couple of months won't make any difference by election day but some token response, however ineffective, will be demanded.
Posted by: dilbert dogbert at May 22, 2006 11:09 PM