Saturday, November 10, 2007

Fed Losing It?

The unofficial intention of the Fed's recent rate cuts was clearly to prop up the stock market and create another bubble there, whose stimulative effect would counteract the negative effects of the bursted housing bubble. This was the trick they pulled of back in 2001, only with the roles of stocks and housing reversed as the strong housing sector counteracted the negative effects of the bursted tech stock bubble.

That is how it has to work in order for monetary inflation to succeed in boosting real output. Asset prices, or more correctly, the type of real investments they represent must be boosted so as to enable higher investments without lower real consumption.

At first it seemed to work, with stock prices ignoring all the bad news about earnings and just kept rising and rose to new all-time highs in October, at least with regards to the S&P 500 and the Dow.

But lately, a barrage of bad news about earnings, with banks reporting almost every day new multi billion dollars losses related to the subprime sector, with GM taking a $36 billion tax charge and with even many non-financial companies reporting deteriorating earnings prospects, despite the boost from the weak dollar from such companies, have induced sell-off after sell-off, and now stocks are in fact lower than before the Fed's September 18 rate cut.

Of course, it can be argued that in the absence of the rate cuts, stock would have been even lower. But nevertheless, it is clear that stock values are simply not rising the way they are needed to in other to counteract the effect of the housing bust.

The really lasting effects of the rate cuts instead simply seem to be a weaker dollar and sharply increasing commodity prices, both of which are likely to fuel consumer price inflation. So, it seems that in this case, monetary expansion will simply not boost output even in the short-term but will simply raise consumer price inflation.

While a weaker dollar will of course help reduce the U.S. trade deficit -or at least the non-petroleum deficit-, which we already see in recent trade statistics, this apparent growth boosting effect is counteracted by the reduction in domestic purchasing power. Particularly in November we are likely to see a sharp reduction in real incomes and with the decline in consumer confidence, this certainly implies a decline in real consumer spending.

I therefore expect real consumer spending to fall for the first time since 1991 during this quarter. Real GDP is also likely to fall, marking the beginning of the recession, at least in terms of trade adjusted terms, but probably also in volume terms.


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