Last week?s meltdown in the stock market, with major indexes falling three percent, is only the latest indication that the economy is in fragile condition. One is even starting to hear the first whispers of the ?R? word (recession). Although I think such expectations are premature, the financial sector of the economy is under growing strain that could burst and spill over into the real economy suddenly and without warning.
The basic problem is a simple one: the Federal Reserve is tightening monetary policy. Historically, this has preceded every major economic slowdown or significant market correction. For example, the Fed began tightening in mid-1999, the stock market peaked in early 2000, and clear signs of a recession were evident by the fall of 2000.
The Fed?s current cycle of tightening began in June 2004, so it is not surprising that we are starting to see the first signs of an impact. Since then, the Fed has almost tripled the federal funds interest rate from one percent to 2.75 percent. Moreover, there is every reason to believe that the Fed will continue tightening for the foreseeable future.
The reason is that the Fed is concerned about the reemergence of inflation. All the early warning signs of this are in evidence: the dollar has been weak on foreign exchange markets, commodities like oil are rising rapidly, housing prices continue to go up at an amazing rate, and the growth of productivity has fallen significantly. Although these factors have yet to seriously impact on consumers, except for the skyrocketing price of gasoline, it is only a matter of time before these fundamental inflationary forces work their way through the system and start raising the Consumer Price Index.
The Fed wants to nip this in the bud before inflationary psychology sets in. Once that happens, inflation tends to feed on itself as workers ask for extra pay to compensate them for expected inflation and lenders start tacking an inflation premium on interest rates. Once that happens, it becomes almost impossible to bring inflation down again without a recession.
The Fed must move gingerly, however, because monetary tightening creates strains in financial markets that can be very dangerous. One reason for this is that many financial institutions have been making easy money borrowing short and lending long. As long as the yield curve slopes upward, this works. But as the Fed pushes up short rates, the yield curve begins to flatten, which can put financial institutions into a bind if they have not been careful enough about hedging themselves.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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