There is No Tightrope

The analogy of Ben Bernanke walking a tightrope between a recession and inflation has become popular of late. However, I suspect that the Federal Reserve increasingly is coming to believe, as I do, that there is no tightrope.

Inflation is here, yes. Commodity prices in general and agricultural prices are skyrocketing. This is something that we talked about here last year. However, the Japanese Scenario is becoming more salient everyday.

As I say regularly to my colleagues, "This is not just sub-prime, this is not just housing. This will get much worse before it gets better"

I am sorry that I do not have the time to post lots of interesting graphs as evidence. What I am worried about, however, is a recession within a recession and the consquences for solvency in the financial sector.

So far there have been some very high losses associated mostly with subprime mortgages. However, this is potentially the tip of the iceberg. Much larger losses will could come from the set of mortgages known as Alt-A, along with consumer credit, commercial real estate loans and corporate loans.

Now, unlike subprime many of these loans will not experience high default rates in the absence of macro events such as declining home prices or rising unemployment. Therefore, those losses are starting to trickle in now. Alt-A today for example is probably at the same point in the rising default cycle as subprime in late 2006.

We see that home prices are falling but what about unemployment. If we look at the business cycle spikes in unemployment are typically led by a slowdown in residential construction and are accompanied by a drop in business investment spending. In fact by the time unemployment spikes residential construction is typically on its way back up.

This time may be different. Business investment is already slowing and unemployment rising. Yet, there is reason to believe that residential construction could fall throughout the rest of the year.

In a sense this means that we will be in the midst of a recession (high unemployment), at the same time that we are experiencing leading indications of a recession (construction slowdown). This sets up the possibility for a vicious cycle in which unemployment further depresses housing which leads to even greater unemployment, or a recession within a recession.

This scenario must be avoided. The Fed should acknowledge that inflation is a problem but should begin to brace the nation for a policy designed to beat back a Japanese style depression without regard for the immediate implications for inflation.