Fed's inflation problem gets some ad hoc help

Every time a piece of weak economic news coincides with a new high in oil and gold prices, we read the next day the Federal Reserve has an "inflation problem," limiting its option of lowering interest rates to resuscitate the economy.

As you work your way through your local morning paper, the next story to catch your eye may be one on the sorry state of the residential real estate market.

Most likely this article will start with an anecdote about Ma and Pa Kettle getting fleeced by their mortgage lender and losing their home through foreclosure.

It will feature a lot of unsavory characters in Irvine, California "" "ground zero" for the subprime lending fandango "" as well as facts and figures on the decline in house prices in your community, the rise in the number of homes for sale and the losses financial institutions are reporting as a result.

The two stories and two phenomena "" falling home prices, rising goods and services prices "" are not mutually exclusive. Nor are they likely to coexist for very long.

"Deflation in asset prices produces losses for lenders, who react by scaling back new lending," says Paul Kasriel, chief economist at the Northern Trust Corp.

Lenders do this for two reasons, he says. "One, they tend to close the barn door after the horse is already out. And two, banks take hits to their capital, so they can't afford to make new loans."

In recent months, banks such as Citigroup, Barclays and UBS have had to look overseas for capital infusions, raising a total of $35.6 billion, most of it from Asia and the West Asia.

Fixed badly
The slowdown in credit growth will damp economic activity, reducing demand for goods and services and exerting downward pressure on prices and incomes.

"Nominal income slows, yet fixed-rate debt doesn't change, so the payment becomes more onerous," Kasriel says.

With the tremors from the residential real estate market working their way first through the financial system and then into other areas of the economy, the Fed's "inflation problem" won't exist for very long. Something's gotta give.

Lessons from Edo
"Japan is a perfect example of what asset price deflation can do for you," Kasriel says. For the last decade, consumer prices in Japan have fallen at an average rate of 0.2 per cent.

Rock-bottom interest rates "" the Bank of Japan's benchmark rate has been below 1 per cent for 12 years "" have done nothing to alleviate the modest deflation, or decline in the price level. Hard to believe, but Japan's double asset bubble "" in real estate and stock prices "" burst in 1989. And it still can't dig out from under.

The slowdown in economic growth and inflation isn't necessarily contemporaneous. Inflation is a lagging indicator, generally peaking after the economy enters recession, according to Kasriel.

A fire can't burn without tinder; inflation can't smolder when the Fed is creating the raw material at a snail's pace. The monetary base, which consists of bank reserves and currency, is growing at an anemic 1.1 per cent rate. In inflation-adjusted terms, the base is contracting.

Real weak
All the talk about the Fed's inflation problem doesn't seem to have registered with the market where expectations are weighed. The spread between nominal and inflation-indexed bonds, a proxy for expected inflation, has been falling.

The yield on the 10-year inflation-indexed Treasury fell to 1.54 per cent last week. A year ago, the yield was 2.4 per cent. This is a real yield. The holder is compensated separately for inflation.

"Real rates fall when activity is weak," Kasriel says. The Fed funds futures market, another forum for voicing expectations about Fed policy, is fully priced for another rate cut on January 30; the only question is whether it will be 25 or 50 basis points.

Mantra ignored
The Fed-can't-ease-because-of-inflation mantra has been with us since before the central bank began to assuage the financial system stress in August, starting with a cut in the discount rate. Even when the source is policy makers themselves, the market turns a deaf ear "" and for good reason.

"Forced to choose between the integrity of the financial system and labor market on the one hand and price stability on the other, most central banks err on the side of the financial system and labor market," says Neal Soss, chief economist at Credit Suisse Group. The Fed isn't about to break that pattern this time.

(The author is a Bloomberg News columnist)