Federal Reserve Fuels Fire Without the Kindling

Commentary by Caroline Baum

Feb. 27 -- The Federal Reserve has been cutting interest rates aggressively since September, a total of 225 basis points in less than five months. More than half of the reduction (125 basis points) in the benchmark overnight rate was delivered in an eight-day period in January.

This must mean that the Fed is throwing caution to the wind, recklessly easing in the face of rising inflation, flooding the system with money and laying the groundwork for the Next Great Inflation, right?

Wrong. There is nothing about the level of the federal funds rate per se that tells you whether policy is easy or tight. The Fed can pretty much put the interbank rate where it wants, passively providing the reserves the banking system demands.

A lower funds rate is generally associated with an easier monetary policy, a higher rate with a tighter one. But if there's tepid demand for credit, banks have little demand for reserves. In that case a low absolute funds rate may not reflect an easy policy.

The funds rate is a means to an end, a price (interest rate) used to deliver a quantity (of money). Right now, the quantity of credit the Fed is creating, the monetary base, is minimal.

The base, which consists of currency and bank reserves, is growing 1.2 percent on a year-over-year basis. With inflation running at 4.3 percent, well, you do the math on real base growth (or shrinkage as it turns out).

Sluggish base growth could mean one of two things: Either banks aren't in a position to extend new loans because of capital inadequacy, or businesses and households are borrowing less.

Government in Action

Either way -- dearth of demand or lack of supply -- it's hard to see how the current elevated increase in the price level can persist when the raw material of inflation is lacking.

``We all know what's happening with oil and other commodity prices,'' says Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. They may be ``relative price increases.''

``In terms of the future, we're supposed to think about the monetary conditions,'' he says. ``And it doesn't seem the fuel (for inflation) is there.''

We can thank the U.S. government for some of the price pressures, at least when it comes to food. It ``legislated higher corn prices,'' Glassman says, referring to the Energy Policy Act of 2005 that established renewable-fuel standards for gasoline. Earlier this month, the Environmental Protection Agency mandated a gasoline blend consisting of at least 7.76 percent ethanol.

That translates into 9 billion gallons of renewable fuel in 2008, according to the EPA. Increased demand for ethanol drives up the price of corn, from which ethanol is derived.

Food Fight

Corn, which is the primary feedstuff for the nation's livestock, ``makes up about 3 percent of the grocery bill,'' affecting the price of everything from fructose to chickens to dairy products, Glassman says. Corn futures prices hit a record $5.47 a bushel this week, an increase of 20 percent since the start of the year. The price of corn has doubled in the past two years.

Food prices rose 4.8 percent in the year ended in January, according to the Bureau of Labor Statistics.

Higher inflation isn't just a matter of food and energy; energy prices are up almost 20 percent in the last 12 months. Core inflation has been edging higher -- from 2.1 percent in September to 2.5 percent last month -- a worrisome development for the Fed even though inflation is a lagging indicator. Policy makers have acknowledged that the downside risks to growth right now are greater than the upside risks to inflation. (Even if they don't say that in so many words, their actions speak it even louder.)

With any luck, inflation expectations won't come unhinged with growth stalling out. If they do, Fed officials will have to put their money where their mouth is or stop talking about expectations as if they have a life of their own.

Similarities to 1990s

The Fed found itself in a similar position in the early 1990s. Banks were in bad shape, a result of speculative lending on commercial real estate. By the time it was over, more U.S. banks and thrifts had gone under than at any time since the Great Depression.

Unlike today, a 3 percent federal funds rate produced a solid increase in the monetary base and narrow money. The broad monetary aggregates registered their slowest growth on record.

The Fed was providing the wherewithal -- cheap credit -- but the banks had to hunker down. They couldn't support credit growth because of inadequate capital. In other words, they said thanks, but no thanks.

Fast forward to 2008, and banks are assuming hundreds of billions of dollars of structured investment vehicles onto their balance sheets. These vehicles need to be financed and are subject to bank capital requirements, a constraint absent in their former life as off-balance-sheet vehicles.

Differences

The fact that banks are tapping the Fed's temporary auction facility instead of the interbank market has no effect on the monetary base. (Please restrain yourself from e-mailing me about the lower quality of collateral the Fed is accepting for TAF loans. I plan to address that issue in a future column.)

This may be a repeat of the 1990s cycle to the extent that real estate losses left banks holding the bag. This time around, however, the raw material for lending just ain't there.