demandside

Podcast Transcript

Monday January 28, 2008

Forecast Friday comes on a Monday again this month

or

Forecasting the results of stimulus and rate cuts

First, stuff

We are up and running again at demandside. We hope you have followed us here. If you are getting this late, in February, you still have not gone to demandside dot net and re-subscribed, or done it through the iTunes store. It is demandside all lower case, one word, or search progressive economics. We are aware of our ineptness during this disruption, and we thank every one of the faithful thirty-nine for not reminding us.

Also, at demandside dot net is the opportunity to purchase the book on CD or download it by chapter. This is our substitute for advertising. Notice the CD’s are tracked, and the downloads are not — which means it is easier to pick your way through on the CDs. We’ve also combined on one CD the Introduction and the chapter on Economic Performance by President, which is a very punchy introduction to theory and evidence. That particular disk comes with a full-color reproduction of the graphs from the book.

And speaking of the book. That long-awaited publication is not confirmed for February 20. We’ll set up the link on that day.

Now back to Forecast Friday. On a Monday.

Note again the detailed forecast is available at demandside dot net. Not too elaborate, but clear and visual and free.

We’ve been calling for a recession, a deep recession, a protracted recession, and today our bias is turning toward a weak recovery. This follows from clear evidence that the nature of the downturn is not appreciated in policy circles — particularly at the Fed — and that the remedies that are being applied will have consequences that are not well thought-out, not effective, nor even leading in the right direction.

Stimulus

The stimulus package announced last week will put $600 in the pockets of one hundred million Americans by June. Some with children will get more. This is a good and worthy thing — but it is exactly what Americans have been doing for themselves for the past dozen years, borrowing from the future to spend now. IF they spend it now. Very likely that many except for the very poor will choose to pay down credit cards or deal with other debt. This is a responsible and intelligent behavior, but it does nothing for stimulus.

Further, that which IS spent may go to consumer discretionaries bought out of inventory or from overseas suppliers. Still no stimulus.

The business tax breaks, which the Republicans apparently preferred to unemployment insurance and food stamps, are a political boondoggle. We have quite enough evidence, much of it from this century, that tax breaks for investment, cuts on capital gains, supply side cuts for the rich, result in no, zip, zero, null, naught, actual business expansion or investment. Businesses invest when they see the prospect of profit, not when they get money from the government. These tax breaks for business are the product of successful lobbying, not good economics. All stimulus should go to the demand side.

If big new earmarks or government projects came up — that would be stimulus. But more tax cuts after a clear experience of supply side cuts which only screwed up the budget and thereby damaged our ability to respond to the current economic downturn are not economically defensible.

As we’ve said, better stimulus would come from revenue sharing with the states and municipalities. These folks are facing prospects for cutbacks that are backing up into their current budgets. This is going to bring forward and amplify the bad times to come. But sharing with them does not seem to be in the cards, so we won’t waste any time on it on Forecast Friday. On a Monday.

Enough about stimulus. What about the rate cuts? More cuts will not substitute for the responsible oversight that has been missing from mortgage markets through financial engineering and derivatives and into — or NOT into — the shadow institutions of hedge funds and private equity.

There are two reasons the Fed should just drop the interest rate in front of it and back away slowly.

One.

We have a credit crunch based on solvency and under-capitalization problems. Liquidity cannot solve this. Liquidity can only extend the agony.

Two.

The liquidity and lower rates that are offered up at the Market’s insistence will, as we pointed out last week with the help of Charles Peabody, not go into real estate and will not stop the fall in prices.

Instead this liquidity will go into commodities, currencies, and maybe into equities. Emerging market debt, another favorite target recently, is looking a bit sickly with the unwinding of the carry trade. We could have meltdowns in some places — in addition to the financial houses — Eastern Europe, for example. It might be similar to the 1990s in Asia and Latin America.

But back to the point. Liquidity will seek out the rising asset, further raising the prices of fuel and food and tradable goods. This is inflation – headline inflation. Core inflation is composed primarily of wages, which will continue their decades of stagnation. Let me repeat that point. All inflation for the past thirty years has come in the presence of stagnating wages and improving productivity. Meaning cost per unit in wages has been going down. Apparently that is still the plan.

Rising headline inflation, and yes, core inflation, too, will mean overreaction by the Fed.

Remember, this is the Ben Bernanke who has testified to the Congressional Joint Economic Committee that quote “In all but the shortest of terms, it is the policy of the Federal Reserve that determines the rate of inflation” unquote.

The new forecasts Bernanke commissioned at the Fed include implicit inflation targets. The European Central Bank has a single mandate of price stability. The IMF’s preferred model for central banks, which at one time was actually imposed on nations as a condition for getting IMF loans, is a bank which has only this one mission. To keep down inflation. This is what the Fed would prefer for itself, or some of its members would anyway.

Unfortunately the Fed has to be concerned about employment. It has a dual mandate, I think resulting from the Humphrey-Hawkins bill in the Carter years. Price stability and employment. It has often treated these as dueling mandates, not dual mandates. In practice, the fed uses employment as a proxy for tailoring monetary policy to the needs of the financial sector.

When inflation kicks up, the Fed will raise rates, or otherwise overreact. There is a lot of pressure to do that right now. The Fed will overreact not only because of its internal preferences, but because bond markets, fixed return markets, and the moneyed matrons who hold these debt securities will demand it. It will be the very short-sighted way to retain the values of these investments. It will be much like the Fed’s reaction to the equity markets today, which is to hear and obey.

But stimulus from rate cuts? No. Rate cuts and liquidity is a poor attempt to bail out a financial sector. Cuts are going to lead directly and emphatically to inflationary pressure. Upward pressure on fuel and food prices is going to be balanced by further downward pressure on manufactures, housing and wages.

Until we go through a long patch of misery, our Forecast is for continued obtuseness in place of budgetary responsibility and demand side recovery.

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