Saturday, February 24, 2007

How Fed Half-Measure Leads America Into Stagflation

As you all(?) presumably know, the Fed stopped its series of rate hikes last year at 5,25%. The Fed at that point, faced a dilemma: raise much more and push America into a recession. Pause, or reverse, and risk accelerating price inflation. The Fed thought they were really smart by pausing at that point. That rate would contain inflation-but not so much that it also pushes America into a recession.

News this week has led me to raise my estimate of the probablity of a recession to 50-60%, up from the "less than 50%, but closer to 50% than zero" estimate of last week.

The news I am refering to is relatively weak economic reports, rising oil prices and most importantly, signs of an emerging meltdown of the American mortgage market, more specifically the so-called subprime mortgage section of it. That is, mortgages issued to people with a high credit risk.

One example of this is the seemingly puzzling fall in bond yields, even as inflation numbers are worse than expected and commodity prices soar. But this appears to be the result, not of generally falling bond yields, but of increased aversion for mortgage related securities, as investors see the increased defaults from sub-prime mortgages. This will, of course, raise mortgage rates even as interest rates on government bonds fall, something which will further depress the housing market and increase the default rate on sub-prime mortgages, which in turn will further raise mortgage rates and so on in a vicious cycle.

For more examples of signs of a subprime mortgage meltdown, see Nouriel Roubini's blog, which have reported extensively about this.

Apparently, another reason for the low bond yields is that traders still hold on to the hope of a Fed rate cut by June. How the Fed will do that while commodity prices soars, and the inflation numbers likely to look awful is a mystery.

So, it looks more and more as though the Fed's attempt to avoid both a recession and inflation by pausing at 5,25% could end up giving America both.


Blogger Ernesto said...

The US is definetely going to enter into a recession which is attracting it's economy like a massive black hole. I have commented before here, in Nouriel's and Mike Shedlock's blogs on this. It has been delayed somewhat by the free fall in oil prices that took place. However, oil is going back up again and the forecast disaster of the residential housing sector is beggining to show. I doubt though whether inflation will go up for the long haul. This will be a consumer-led recession and the probability is higher that prices will, eventually, diminish and not increase. The future scenario appears to be more deflationary than inflationary.


4:33 AM  

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