Wednesday, March 01, 2006

Fed to Consumers: Drop Dead!

Federal Reserve interest rate policy is difficult to parse. However, if we look at recent economic outcomes, it appears to make sense to think of Fed policy as frontal attack on consumers.

In setting interest rates, the Fed ignores the impact of consumer-costly spiking energy and food prices. Its rate increases squeeze consumers who used adjustable rate mortgages to buy homes whose prices have increasingly been climbing out of reach. And its rate increases constrict business lending which reduces demand for labor – by cutting expansion capital -- while increasing its supply – through corporate bankruptcies -- a lethal recipe for wage reductions.

According to
recent comments by Fed Chair Ben Bernanke -- the Federal Reserve does not take into account the CPI in its interest rate decisions. Instead it considers the “core rate” which excludes energy and food.

What the Fed measures is not consistent with what matters to consumers’ monthly budgets. For example, consumers are not in a position to exclude energy and food from their personal inflation calculations. Consumers need energy to heat their homes and power their cars and they need food in order to survive.

Since the Federal Reserve does not take these requirements into consideration when setting interest rates, it may tend to underestimate the consumer spending impact -- 66% of GDP growth – of its policies.

It appears that the Fed’s key constituent is not the consumer but long-term bond investors. Bond investors want to be assured that the Fed’s policy will tamp down inflationary expectations which could threaten the value of long-term bonds.

This helps explain why the Fed would pursue policies that harm the consumer whose interests might diverge from those of the long-term bond investor. With so many consumers having purchased homes using adjustable rate mortgages, an increase in short-term rates is likely to raise their monthly mortgage payments – further squeezing citizens who are also paying record energy prices.

The Fed’s interest rate power is a blunt instrument. It is unclear what effect raising the Fed funds rate has had on prices. It has clearly not had much of an impact on energy and food prices. It is probably affecting the amount of money banks are willing to lend since the inverted yield curve makes it increasingly unprofitable for banks to take the risk of lending money when they can invest it more profitably in low-risk short-term government bonds.

Short-term rate increases could drive down wages – a core inflation component which was up 2.4% in the fourth quarter. The cutback in lending resulting from an inverted yield curve could affect business expansion and result in more corporate bankruptcies as banks tighten lending standards. Such bankruptcies would result in layoffs which would increase the supply of labor. This increased labor supply, coupled with lower demand resulting from the capital contraction could reduce upward pressure on wages.

While the Fed does not set out to harm consumers, it appears to me that this is the unintended consequence. And if consumers suffer, so will GDP growth.


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