May 31 2007 8:50AM | Permalink | Email this | Comments (1) |
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We are sticking to our forecast that interest rates will remain about where they are now well into next year. This means that credit costs will not be a restraint on construction spending, although access to mortgage credit for financially marginal families will continue to depress the housing market.

The Federal Reserve Board is wisely resisting calls to cut credit costs to stimulate spending after a year of subpar economic growth. Each day of bad economic news prompts some money managers to gamble on a rate cut leading to a brief drop in short term rates. Then better news reverses the movement in rates. Overall, the average weekly yield for the 1-Year Treasury bill has been stuck in a very narrow range between 4.86% and 5.10% for ten months.

The Board has properly assessed the relationship between today’s restraints on spending and credit costs. High credit cost did not cause the problems in the oil, housing and auto markets and lower credit costs can not fix these problems. While economic growth is well below potential, there is little risk that it will drop into the negative zone. There are enough strong sectors in the economy, including nonresidential construction, for positive growth to continue. The consensus outlook is that economic growth will quicken during 2007.

A pickup in inflation beyond the current 2% plus pace is the Board’s worst nightmare. They have recently expressed concern that out imported inflation — from high commodity prices and a depreciating dollar — is beginning to spread into wages. In the past year, annual wage gains have accelerated from 3% to 6% in the high growth markets in the economy which includes nonresidential construction and business services.

If this persists it would eventually set off a wage-price spiral similar to what happened thirty years ago. Remember President Nixon’s wage and price controls. These did not work so next we had President Ford’s “Whip Inflation Now” buttons. These did not work either which led to President Carter’s lectures on the morality of pricing and spending. Finally President Reagan solved the problem with painful budget cuts. Economy growth was depressed for more than a decade. The Federal Reserve Board does not want to repeat this. The Board will refuse to spur growth now at the expense of a future rise in inflation which would depress economic growth for many years.

Just when we need it we have a fresh example of what happens to a country that lets inflation get out of hand. Zimbabwe, formerly Southern Rhodesia, is unsuccessfully battling hyperinflation and is quickly descending into a living hell. The unemployment rate is reported to be 70%. Three million people have fled. Death from starvation is now common in a country that once was a major grain exporter.

Yes, it is unlikely that rising inflation could cause a similar problem in the US. But there are many examples of reasonably modern, industrial countries that went well down this path before they changed policies. Each of them suffered a sharp rise in unemployment, mass emigration, social violence, the depreciation of private assets, neglect of public infrastructure and an unconstitutional change of government. In the last twenty years, the list includes Argentina (1989), Serbia (1993), Brazil (1994) and Turkey (2001).

The Federal Reserve Board does not want to start down this path. While credit costs will be steady for the next year when there is some slack in the economy, the bias toward higher credit costs will return when that slack has been used up.