Federal Reserve & Interest Rates

The U.S. budget is expected to run a deficit of about $1.8 trillion for the fiscal year that ends in September.  Even before adding in the estimated costs of the proposed healthcare reform bill making it’s way through Congress, the next couple of years will also likely see trillion dollar deficits as well.

Although inflation isn’t a concern for the time being, a lot of people are watching out for it in the corner of their eye.  Noted investment guru Warren Buffet also raised concerns about the long term risks to the economy in a piece this week in the New York Times.

No one really likes to talk about it, but it’s a big problem that isn’t going away.  Can we really count on a future Congress to deal with this problem in an appropriate manner?  Not likely if you go by how past Congresses dodged the growing Medicare and healthcare problems to the point where the current Congress has to deal with the problem during the worst financial crisis since the Great Depression.

That being said no one really knows when or how much of the money the government lent out to financial institutions it will get back.  Some people are saying taxpayers will be on the hook for most of it, while others are saying the government may actually turn a profit by selling it’s equity stakes when markets recover.

It’s not a problem as long as there is enough demand for U.S. treasuries but once it passes that tipping point all bets are off.  This country hasn’t really had an inflation problem since the recession of the 1980’s but the one that’s coming could make that one look like a distant dream.

Now the Fed could fight it by raising interest rates but that would also send economic growth down at the same time.  Since no one knows who the next Chairman of the Federal Reserve will be next year, we don’t know if a future Fed will place a premium on fighting inflation or maximizing employment.

There are too many variables to the problem to accurately determine how this will all play out but it is a cause for concern.

The Open Market Committee once again agreed to keep interest rates unchanged at between 0% and .25% this week.  As long as inflation concerns remain muted they would prefer to keep rates as low as possible in order to stimulate a faster recovery.

Although last quarter’s GDP numbers were still negative, they were better than what many economist had forecast and there are increasing signs that economic growth will turn positive by year’s end.  While that may be the case, it should be pointed out that with consumers unable to do so, it has fallen to the federal government to try to spend it’s way out of the current recession.

It will still be some time before consumers will feel like there’s an actual recovery with unemployment expected to climb up to the end of the year.  Whether or not the Fed will be able to keep rates at their current level until there is actual job growth remains the big question.

Much of this will depend on how the price of oil reacts as economic conditions start to improve, if speculators start pushing the price up once again, like they did a year ago, it could quickly derail any chance of a timely recovery.   That would also likely lead to a rise in commodity prices in general but at this point the demand figures would seem to preclude that.

If rates can remain low for an extended period of time, it would also go a long way in helping out the housing markets, which has seen increased buying activity in recent months.  However, high foreclosure rates remains a problem for the banking system, clogging their balance sheets with toxic assets.

So even if GDP does start to rise once again in the next couple of quarters, it doesn’t mean by any stretch of the imagination that we are out of the woods yet.

There is a big debate going on right now on whether we should be concerned with inflation.  10 year Treasury securities have started to creep up recently, but it should come as no surprise as everyone knows that the government will need to sell substantial amounts of debt in the next few years.

There is no question that all the debt the government is piling up will increase inflationary pressures down the road.  However, the reason it’s not a problem for the moment because demand is so weak and the fact of the matter is, it could be quite some time before that demand recovers.

The Fed has in the past, shown it’s resolve in fighting inflation and there is no reason to believe that they won’t take the necessary steps to combat it once again if they feel it becomes a problem.  The main problem I see down the road is that the economy may be entering in a period of higher interest rates, which will be the likely outcome once all that government debt starts to flood the market.

The Fed will probably have to maintain it’s balance sheet operations and continue to be active participants in the Treasuries market if they don’t want those rates to get out of hand.  Even once the recession ends, it’s expected to take a long time for the economy to recover to it’s former level and that time frame may be lengthened if the Fed is forced to raise interest rates sooner than they wish.

A lot will depend on how quickly the financial system can recover and whether or not the government will have to spend anymore money to shore it up.  During the financial crisis the Fed has had to become the main driver of credit expansion in place of private investment once secondary markets for securitized loans started shutting down.  Since short term inflation expectations have been low, the Fed has had the leeway to act aggressively but that may not be the case a few years down the road if and when another recession occurs.

At the moment it’s too early to tell whether or not inflation will become a problem, as we’ve already glaringly seen with the price of oil for instance.  Everyone thought inflation was a big problem when oil hit $140 but not when it was under $40 a few months later.