Monday, July 7, 2008

Is There Really a Conundrum?

I don't blog much about economics and there is a reason for that - I find the term "dismal science" a little bit too charitable for the subject. So go easy on me after reading this.

There is this consensus building in the market (God, how I hate that word) that the Federal Reserve is caught between a "rock and a hard place." The Fed wants to raise interest rates to fight inflation expectations that are clearly building in our society. This can be seen in the two charts below. The first is Household inflation expectations, and the second is the adjusted 10-year TIPS-derived expected inflation:

It is unable to fight these inflation expectations by raising rates since the economy is so fragile, and it is thought that any increase in short term rates will crush any incipient recovery in its womb.

But would higher rates actually have that effect? It seems the problem is more availability of credit, not the cost of credit. This can be seen in the results of the latest Senior Loan Officer Opinion Survey on bank lending practices conducted quarterly by the Federal Reserve. The survey reports the percent of lenders who,in this case, have tightened lending standards over the previous three months.

"55 percent of domestic banks—up from about 30 percent in the January survey—reported tightening lending standards on C&I loans to large and middle-market firms over the past three months."

"80 percent of domestic banks and 55 percent of foreign banks—fractions similar to those in the January survey—reported tightening their lending standards on commercial real estate loans over the past three months."

"60 percent of domestic respondents—a somewhat larger fraction than in the January survey—indicated that they had tightened their lending standards on prime mortgages."

An article in the Financial Times yesterday had the quote from a banker "...and the banks are canceling revolvers wherever they can.”

It might be better to raise rates to defend our currency. This would have the dual effect of breaking the upward momentum of Oil as traders will have to find another excuse to push it up. Once Oil starts trading back toward the level it should based on fundamentals, inflation expectations should come down. If gasoline prices follow oil down, then that will free up money for discretionary consumer spending.

Raising rates will have the deleterious effect of hurting those homeowners with adjustable rate mortgage resets, but the opening up of credit markets for them may be a side effect of a stronger dollar.