Investors can indeed run from places and commodities they now deem too risky, but there seems to be no place to hide. True, American share prices have done well, and provided something of a safe haven for nervous money, but only when compared with markets in developing countries. That’s because, as the gang members in West Side Story informed the local policeman, “We’ve got troubles of our own”.
One such trouble seems to be uncertainty over whether Ben Bernanke, chairman of the Federal Reserve Board, is up to the job. Nobody doubts his credentials as an economist. Rather, it is because some observers doubt Bernanke’s ability to communicate his intentions to the markets in an orderly way. First he hints that the series of rate increases might end, or at least be suspended temporarily. Then he lets slip an unguarded remark to a television journalist at a dinner party, suggesting he had been misunderstood. Then he attempts to burnish his credentials as an inflation fighter by publicly restating his determination to keep the inflation genie bottled up.
Another problem is that investors fear a return to the bad old days of stagflation, with inflation rising and the economy sinking. Their fears about resurgent inflation were fanned last week by the release of data that show that in the past three months the core rate of inflation (excluding food and fuel) has risen at an annual rate of 3.8%, far above the 1%-2% that the Fed chairman and his colleagues have been trumpeting as their “comfort zone”.
So, as we have been saying for some time, the Fed cannot stop ratcheting up of rates and will have to go beyond its current “5% solution” if Bernanke is not to be seen as so rattled by recent market turmoil that he throws in the towel and lets inflation get out of hand. The markets are now certain that another increase, the 17th, will bring rates to 5.25% at the end of this month, and are assigning a 50-50 probability to a further increase in the summer.
There is a crowd that traditionally worries about Fed “overshoot” — interest-rate increases that not only slow the economy but throw it into recession — but they are not the only ones on edge. A new crop of Fed critics is abroad in the post-Greenspan land. They make three points.
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First, it is not the Fed’s job to look in the rear-view mirror, which is what it will be doing if it gets spooked by recent inflation data. It has to look ahead. And this is one instance in which the past is not prologue.
That is because, second, the economy is already slowing, and doesn’t need the Fed to tramp down harder on the brakes. As the Fed’s most recent summary of current economic conditions (known as The Beige Book) points out, there are now “some signs of deceleration” in the rate at which the economy is expanding. Among other signs of a cooling, the Fed report noted that the growth of consumer spending has slowed. That, say economists at Goldman Sachs, can be traced to MEW — an acronym with which readers might want to become familiar because they will see more and more references to it.
MEW is mortgage equity withdrawal — the cashing out of the rising equity value of a home. American consumers have loved their MEWs, and used their homes as cash machines to fund their visits to the shopping malls. That process seems to be slowing, partly because consumers’ appetites for new cars and home furnishings have waned in response to high energy prices, which Bernanke last weekend declared to be a permanent feature of American life. A slowing housing market also has knock-on effects on total construction, which in turn is reflected in recent weak employment data. That’s another reason consumers might be ready to tighten their belts.
The third criticism of the Fed is that its models are too parochial. The Fed worries that America’s low 4.6% unemployment rate is setting the stage for a round of wage increases, and that growing pressure on America's productive capacity means that we are about to see the return of corporate “pricing power”. But in a globalised economy, with millions of Chinese willing to work at daily wages far below what Americans get for an hour’s work, tight national labour markets create less inflationary pressure than in the past.
So say the critics, who argue that a sensible look in a clear crystal ball would tell the Fed to stay its hand. The slowing of the economy will ease inflationary pressures, and further interest-rate increases will only throw a slowing economy into recession.
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Theirs is a voice in the wilderness. Too many Fed governors and regional bank presidents — about a dozen at last count — have spoken out in recent days to join Bernanke in signalling that investors have at least one, and probably two further interest-rate increases in their futures. That will slow not only the American economic locomotive, but the economies it drags along. Not enough to trigger a recession in a still robust economy. But enough to keep investors on the edge of their seats.
Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute