WASHINGTON - Worries about a deep recession — not a shallow one — drove Federal Reserve policymakers to slash a key interest rate last month, meeting minutes show.
Even as the Fed battled in almost unprecedented fashion to stem a widening credit and housing slump, some members fretted over the possibility of a “prolonged and severe” economic downturn. It was in that environment that they voted — with two dissents — to cut its most important interest rate by three-quarters of a percentage point to 2.25 percent. That action capped the most aggressive Fed intervention in a quarter-century.
Some Fed policymakers thought that such a widening recession could not be ruled out given the “further restriction of credit availability and ongoing weakness in the housing market,” according to the meeting minutes that were made public Tuesday.
What we have here is really a classic problem for the Federal Reserve. The Fed knew that the economy was slowing down. And in a slowing economy, the Feds cut the federal funds interest rate it charges for loaning money to banks. The banks, in turn, lowers interest rates they charge to consumers for business, home, auto, and equity loans. Consumers take the loans for purchasing homes, businesses, autos, and help inject spending into the economy, allowing the economy to grow out of the recession. It is a simple model, but it gives you the idea of how the Fed's cut in interest rates can help jump-start the U.S. economy into a recovery.
The problem is that this simple model of the Fed cutting interest rates to stimulate the U.S. economy will not work. First, the banking and financial industry is saddled with all sorts of problems stemming from the housing collapse, and the bad investments into the subprime loans for housing. If the banks and financial institutions were not handing out so many subprime and adjustable-rate mortgage home loans to American consumers, they were pre-packaging those loans into mortgage-backed investment securities to sell to anyone who wanted them. When the housing boom collapsed, the banks ended up being saddled with a lot of foreclosed homes that have dropped in value to what they were originally sold. In other words, the banks and financial institutions are stuck with huge losses stemming from these over-priced homes that they can not sell--homes that are continuing to drop in value, creating even more losses. Because these losses are sitting on their books, the banks are certainly not going to start loaning out so much money to Americans wanting to buy homes, unless those Americans have an almost platinum credit rating and a huge down payment to go with it--regardless of whether the Fed lowers the interest rate. So we've got a credit crunch here taking place, even as the interest rates have been dropping.
The second problem here is energy prices--oil at over $100 a barrel. Gas prices have certainly risen because of the high oil prices. And you can bet that the volatile food prices have also risen, because such food is transported to stores via trucks, which uses fuel to run on. What I am trying to say here is that we could be in a period of an inflationary cycle. We've got the war in Iraq that is costing us billions of dollars--dollars that are being printed by the U.S. Treasury. We've got prices rising due to the increasing costs of energy. And we've got the Fed dropping interest rates in an attempt to continue injecting liquidity into this U.S. economy. Are we heading into a period of stagflation? I think this was the huge issue that Fed members had difficulty to resolve. Consider this from the MSNBC story:
Two Fed members — Charles Plosser, president of the Federal Reserve Bank of Philadelphia, and Richard Fisher, president of the Federal Reserve Bank of Dallas — opposed such a big rate reduction, however. They favored a smaller cut because of concerns about a potential inflation flare-up. It was a crack in the mostly unified front that the fed often has projected to the public.
The minutes of the closed-door March meeting underscored the economic cross-currents pulling at Fed policymakers.
“With the uncertainties in the outlook for both economic activity and inflation elevated, members noted that appropriately calibrating the stance of (interest-rate) policy was difficult,” the minutes stated.
On the one hand, the Fed has been urgently moving to prevent the trio of economic woes — housing, credit and financial— from plunging the country into a deep recession. On the other hand, with soaring energy prices and high food costs, policymakers realize that they can’t afford to let inflation get out of control, either.
There it is. The Fed is stuck trying to prevent a collapse of the financial markets due to the housing and credit woes. They want to cut the interest rate to help the financial market, otherwise the U.S. economy enters into a recession. However, with food and energy prices soaring, the threat of inflation emerges if the Fed injects too much liquidity into the market. You have an almost perfect recipe for stagflation to emerge here. Continuing with the MSNBC story:
Even with the big interest rate reduction in March, most Fed members saw overall inflation moderating in coming quarters, the minutes said. However, inflation pressures had picked up even as economic growth had weakened, the minutes added, suggesting that uncertainty clouded the inflation outlook.
Plosser and Fisher — the two who opposed the hefty three-quarter-point reduction in March — were “concerned that inflation expectations could potentially become unhinged,” according to the minutes. If people, investors and businesses expect prices to rise sharply, they’ll act in ways that will make inflation worse. Once inflation takes hold, it is hard to break.”
What Plosser and Fisher were worried is that if Americans feel that inflation is bearing down upon them, they are going to cut back on spending. And with the U.S. economy teetering on this brink of a deep recession, any cutback in consumer spending, coupled with the Fed's cutting of interest rates, will cause the situation to go from bad to worst. And let us not forget that it is not just the Fed that is injecting more dollars into the U.S. economy--we still have a war in Iraq that will add even more billions of dollars in both the U.S. economy and the world economy. It is almost like a perfect storm of economic ills that are bearing down on this country. And our current crop of leaders are completely paralyzed as to how to prepare for this monster storm.
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