Bear Hawk(ish)

I find myself in a unique position among econo-commentators. On the one hand I am bearish about the medium term prospects for the US domestic economy. On the other I am not yet convinced that this demands large cuts in the funds rate.

First, the bear case. It is difficult to imagine a scenario under which domestic consumption does not experience a significant slowdown over the next 18 months. To wax nerdy for a moment the structured finance revolution that gave birth to the housing boom was akin to a massive technological advance for the US, or so we thought.

It seemed as if considerable amounts of risk could be redistributed and managed for much lower costs than in the past. Risk drives a wedge between the interest rate that borrowers are willing and able to pay and the rate that lenders are willing to accept. A reduction in risk means that there are a whole host of new transactions that are now possible.

Like the internet bubble, however, the credit bubble was based on over optimistic assumptions about the power of this technology. Incidentally, the credit bubble was also sparked by large increases in computing power, but that is another story.

The upshot is that even if consumers feel no wealth or collateral effects from housing their borrowing capacity will be reduced.

In addition, we have a number of traditional forces at work. Banks are seeing huge losses on their balance sheets which will lead them to reduce lending. Consumers are facing a decline in home equity which will reduce the collateral they have to post against loans. And, finally people will at least feel poorer as a result of declining housing prices. All of these forces work against consumer spending.


So in the face of all of this why am I not advocating massive rate cuts? Part of the problem is Fed credibility. We experienced a good bit of pain in the early 80s and 90s to get the inflation rate down. The willingness of the Fed to risk those episodes did a lot to promote credibility on the inflation front. I would hate to see all go down the drain now.

Relatedly there is the issue of growth in the rest of the world. It is that growth that is creating inflation pressures, and it is also that growth which has the potential to provide some support to the US economy.

Net exports are surging and will probably continue to do so as domestic consumption slows, foreign consumption rises and the dollar shrinks. Whether or not net exports can prevent the US from sliding into recession is an open question. I tend to doubt it, but the jury is not in yet.

What does occur to me, however, is that by charting a relatively steady course the Fed will allow the trade deficit to unwind in an orderly fashion. Cutting rates aggressively generates a lot of uncertainty.

On the one hand basic theory predicts that a lower funds rate would depress the dollar further and push up net exports. On the other hand, easier money could alleviate consumer pressures, increase US domestic profits and lift the dollar on rising equity values.

If we experience the first case we risk seeing the dollar fall off a cliff. If we experience the second case we suspend the dollar ever higher against fundamentals. The steady but seemingly controlled decline we are experiencing now seems to be working and I don't see why we would want to mess with that.

We keep domestic inflation very low, we let rising commodity and import prices play themselves out. We allow the trade deficit to correct itself through lower US consumption, a weaker dollar and growth overseas.

The result will be a painful course correction for the US economy, but a much needed one that will put the global economy on a more sound footing.