The fashionable cliché about the Federal Reserve’s current monetary policy is that it has created a “Goldilocks economy” in the United States, in which the economic porridge is neither too hot nor too cold, and moderate non-inflationary growth can continue ad infinitum. However, what if the “path of steady growth” onto which the Fed has led the U.S. economy is a cul de sac? What if the porridge, however perfect in temperature, is in reality poisoned?
In the Three Bears fairy tale, the little girl Goldilocks goes into the Bears’ house and finds three bowls of porridge: a large bowl, for Daddy Bear, which is too hot, a medium sized bowl, for Mummy Bear, which is too cold and a little bowl, for Baby Bear, which is just right. Consequently, the little delinquent scarfs up Baby Bear’s porridge, after which she proceeds to wreck the furniture. The tale is surprisingly variable for one so well-known, and also surprisingly new; it postdates the Brothers Grimm (who published in 1812-14) with its first published version (in which Goldilocks is an old woman) by Robert Southey in 1837 and the Goldilocks character herself first appearing as late as 1904.
The “Goldilocks” monetary policy cliché supposes that if monetary policy is too expansionary, it will cause inflation, while a contractionary policy will tip the United States into recession. A “Goldilocks” policy avoids both of these errors and produces a moderately paced, stable economic expansion that avoids inflation but can continue for several years at close to the long term potential growth rate of U.S. Gross Domestic Product.
The claim that the Fed can engineer a Goldilocks economy has two requirements, only one of which is under the Fed’s control. The first is for a high level of skill at the Fed itself, supposedly guaranteed under outgoing Chairman Alan Greenspan but a more unknown quantity at first under the new Chairman Ben Bernanke.
The second is for a Goldilocks economy to be feasible, in other words for the Goldilocks solution to the complex economic equation to exist. It is at least theoretically possible for interest rates to be high enough to produce a recession while at the same time being too low to prevent a resurgence in inflation. Britain’s position in 1974, when very rapid money supply growth produced both a deep recession and inflation that peaked in 1975 at 25 percent per annum, is an example where no monetary policy could have avoided either high inflation or a recession, indeed both were probably inevitable.
The United States in 1931 may have been another such example; after the collapse of the Bank of the United States in December 1930 it was probably impossible for the Fed to create money fast enough to prevent a severe economic downturn. The collapse of confidence in the banking sector, which caused a massive withdrawal of deposits and de-leveraging of the sector, almost certainly destroyed the supply of money faster than the Fed could have created it – Bernanke’s favorite solution “dropping dollar bills from helicopters” was of course impossible before the invention of the helicopter!
Both these pathological situations were the result of a combination of bad policy and external shocks. In 1974 Britain, the external rise in oil prices at the end of 1973 combined with an excessive growth in government spending by both the Edward Heath and Harold Wilson governments in 1971-75, and an over-rapid “dash for growth” increase in money supply in 1972-73. Not only was Goldilocks’ porridge nowhere to be found in 1974-75, but economic collapse was only narrowly averted, with the London Stock Exchange sinking in December 1974 to a lower real level than after the 1940 evacuation of Dunkirk. In the 1930-31 United States, after the 1929 stock market crash hit confidence, international trade, still fragile after the disruption of World War I, was dealt a staggering blow by the protectionist Smoot-Hawley Tariff of June 1930. Heavy politically directed government spending and a sharp tax increase in early 1932 made matters still worse, so in this case, something close to a complete economic collapse did indeed occur.
There’s no question that Fed policy and the George W. Bush administration’s tax cuts (particularly the dividend tax cut) have since early 2003 produced an economy that is at first glance pretty close to a Goldilocks state in spite of considerable global difficulties. Output has risen at a steady 3-4 percent, accompanied by favorable productivity numbers. Inflation has remained fairly low in spite of a huge increase in world commodity prices, being 3.5 percent at the consumer level in the 12 months to November 2005. The Federal budget deficit peaked at around 4 percent of GDP in the year to October 2004, then declined to about 3 percent of GDP in the following year. The stock market has recovered nicely from its late 2002 low; the Standard and Poors 500 Index is up more than 50 percent from that low and within about 15 percent of its 2000 high, which in retrospect was over-inflated by the tech sector bubble. Only the U.S. balance of payments deficit, at about $800 billion in 2005, about 6.5 percent of GDP, suggests that there may be more than modest imbalances in the system.
The Fed, dropping the Federal Funds interest rate to 1 percent in 2002 and holding it there for almost 2 years, then raising it steadily to 4¼ percent, appears indeed to have avoided “too hot” inflation and “too cold” deflation/recession, even if the current position seems biased somewhat towards the “hot” side. Goldilocks should be happy, the greedy little thing.
I don’t generally believe in “chartist” theories of stock market prediction, but some chart formations offer useful insights into economic reality. One such is the “triangle” a formation in which the price fluctuates between two converging lines, moving in ever narrower and narrower bounds until the lines meet, at which point the price leaves the triangle and moves sharply in one direction or the other.
The U.S. economy appears to have established itself in such a formation. In 2002-03, when interest rates first dropped, inflation was very low, around 1 percent, and so even a 1 percent interest rate was close to zero in real terms. Economic output was well below its potential, and continued to be adversely affected by the capital-spending drop-off following the stock market downturn of 2000-02. Consequently, inflation was only a distant threat, and the Fed could concentrate on stimulating economic output without worrying about the inflationary effects of its rapid money creation.
By 2004, the surge in oil prices was beginning to cause an uptick in consumer price inflation, so when the Fed began to tighten short term interest rates, it did so from a position where they were negative in real terms. As short term rates rose, inflation rose also, so the Fed has been unable to bring about the substantially positive short term real interest rates that are necessary to reduce inflation. Currently, the Federal Funds rate is at 4¼ percent, while inflation as represented by the Producer Price Index was reported Friday as having run at 5.4 percent over the past 12 months. Consumer price index inflation in the 12 months to November was only 3.5 percent, but that was probably a short term downtick. Consumer price inflation in December 2004 was minus 0.4 percent so it is likely that the December figure, to be reported Wednesday, will bring the 12 month rate of consumer price inflation once more above 4 percent.
Oil and commodity prices also reflect a continuing surge in inflation. Oil closed just below $64 per barrel Friday, while gold has doubled since 2000 to a level of $557, its highest since the inflationary panic of 1980.
The “core” U.S. consumer price inflation rate remains just above the 2 percent that is believed to be Bernanke’s inflation target. However that figure excludes food and energy. Since real consumers must eat and heat their homes, their financial and investment decisions depend on the real interest rate, based on true inflation not “core” inflation.
In the real economy, the U.S. housing boom appears to have peaked, with the Mortgage Bankers Association weekly survey of mortgage applications recently running at around 25 percent below its peak levels. In particular, the levels of mortgage refinancing are running at a fraction of the peak, in spite of the fact that long term interest rates and mortgage rates remain close to their 40 year lows. Since much of the ebullience in retail sales in recent years has been financed by home mortgage refinancing “takeout” consumer spending growth is muted, and likely to remain so. Retail sales growth in December was lower than expected at 0.7 percent, and the year on year rise was 6.4 percent, not very impressive when consumer price inflation is running at more than 4 percent per annum. It is thus likely that real GDP growth for the fourth quarter, the advance estimate for which is to be announced January 27, will be significantly below the 3-4 percent level seen so far in 2005.
The Federal Open Market Committee indicated at its meeting in December that it believed it had nearly finished raising the Federal Funds interest rate. Slowing economic growth, together with a poor automobile market and a likely housing downturn in 2006, together confirm the Fed in its view that a peak in the Federal Funds rate of 5 percent or below is needed to avoid a U.S. recession. First indications for fourth quarter 2005 earnings are that corporate earnings growth is slowing; this would further confirm the Fed’s view and generally lead to stock market weakness.
On the other hand, a real Federal Funds rate of at least 3 percent is normally needed to fight a rise in inflation. With consumer price inflation around 4 percent, that implies a required Federal Funds rate of around 7 percent.
If Goldilocks requires a Federal Funds interest rate that is simultaneously below 5 percent and around 7 percent, she’s not going to get much porridge. If the Fed leaves the Federal Funds rate below 5 percent her Fed-provided porridge may prove toxic. In that event, still higher inflation will appear which will be followed by a panic rise in interest rates and a 1970s style inflationary recession, with a corresponding crash in bond prices, stock prices and housing prices.
All in all, the outlook appears positive only for the Bears!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.