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.
The place where the greatest danger lies is with Fannie Mae and Freddie Mac, the two giant government mortgage lenders. Their portfolios are now so large?in the trillions of dollars?that even the tiniest mistake by them could roil markets. Evidence that some of Fannie Mae?s managers may have been manipulating its finances for personal gain is reason enough to worry about what else may be going on there. That is one reason why Congress and the Bush Administration have been stepping up their oversight of Fannie and Freddie.
Another source of concern in financial markets is the impending retirement of Alan Greenspan as chairman of the Fed. Having served in this position for almost 20 years, an entire generation of bankers and bond traders have never know anyone else in this critical position during their professional lives. It is not known who his replacement will be, but even if the choice is excellent there is bound to be some financial unrest during the transition.
Lastly, there are the dreaded ?twin deficits? looming over financial markets. Huge budget and current account deficits mean that vast amounts of capital flows are necessary to keep them funded. So far, this has gone well, but that is largely because the Chinese have been so accommodating about financing them?effectively financing their own exports by buying large quantities of U.S. Treasury securities with their export earnings.
But now the U.S. is strongly pressuring China to stop doing this in order to allow its currency to rise against the dollar. It is hoped that this will reduce China?s production advantage in dollar terms and bring down the bilateral trade deficit. However, the cost to the U.S. economy if this happens could be greater than the potential gain. At least in the short run, any scale-back in China?s buying of Treasury securities might cause interest rates to spike very quickly. This could prick the housing bubble and bring down home prices, eroding personal wealth and putting a squeeze on those with floating rate mortgages.
Hopefully, this can all be managed smoothly and without either a recession or a market break. But it will take great skill and a lot of luck to avoid both.