Rate Watch #626 This Guy Thinks We Need a Dose of Inflation

July 11, 2008
by Dick Lepre

It was not fundamentals but words about FHLMC & FNMA this week which should be of concern to those of us who are interested in the mortgage market. This started when a Lehman analyst said that FHLMC & FNMA had to take significant write downs consequent to new accounting rules. The guy who runs OFHEO said, in effect, "Not so fast! We regulate FHLMC and FNMA and they do not have to follow those rules".

Then William Poole who used to be President of the St. Louis Fed continued the theme suggesting that FHLMC had negative net worth if the portfolio was marked to market. The Secretary of the Treasury chimed in backing OFHEO and FHLMC and FNMA.

In has always been the case that investors regard FNMA & FHLMC debt as if it is backed by the U.S. government even though it is not explicitly the case. If this gets worse the Fed will have to bail out the GSEs. The concerns are threefold: 1) the equity value of the two companies 2) the increased borrowing costs suffered by the GSEs will increase mortgage rates 3) the Fed's ability to help FHLMC and FNMA out is compromised because it has committed so much of its own portfolio of Treasuries to help banks and Wall Street firms.

It may well be the case that there are only two solutions to this:

1) the Fed can increase money supply (sounds better than "print money") and use that to help FHLMC & FNMA or

2) Congress can act immediately to create a new class of debt which is Treasury guarantee of GSE paper. Assuming that Congress could do this the problems are that this must be immediate as in this weekend and also that the Federal Reserve has to deal with, in effect, monetizing this once it exists.

The fact that the solution to this problem is beyond the ability of the Fed to help is disquieting. For me to suggest that Congress must act and must act now makes me uncomfortable.

This issue is important and has unfolded too rapidly for me to treat it more extensively.

One Guy's View on Inflation

A few weeks ago a ran across this article by Paul McCulley of PIMCO. I found it an interesting point of view even though I saw some incompleteness in it. If you are interested read his piece.

The Classic Comics version is as follows:

Soaring commodity prices (and let's be clear: commodity prices have not simply been rising the have been soaring) lead to a negative real terms of trade shock. In plain English the average guy has to work more hours to fill up his tank and stomach. In any sense this makes up less rich or more poor or just plain worse off.

The question is "what should the Fed do about this?" McCulley quotes Fed Vice Chairman Don Kohn:

“… an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains."

(The text of Kohn's complete speech is here.)

I think that what these folks are really talking about is this: there are times when the "best" thing for the economy is not the best thing for politicians. Politicians goals are short-term. Economists are (at least trying to) think long-term. Even though it might seem that the goals of the Fed should be to lower unemployment and lower inflation that is not the best policy. The best policy is to allow unemployment to rise a bit. That will translate into lower real wages and profits.

Implicitly the Fed needs to allow negative real interest rates (Fed funds less than inflation) and it is here that McCulley addresses the concern that this would set off a wage-price spiral akin to that started in the 1970's which was also induced by an oil price shock. Will negative real rates set off an inflationary spiral? McCulley believes not but I am a bit skeptical. He points out that the global, less unionized labor force reduces the correlation between prices and wages. The percentage of the U.S. labor force which is unionized is about half what it was when the wage-price spiral started in the 1970's.

So what McCulley is saying is that labor has so little clout that price inflation will not trigger wage inflation as it did in the 1970's.

In this scenario everyone bears the pain. Workers get lower real wages. Companies make smaller profits and the wealthy suffer the deflation of their wealth as interest rates remain less than inflation.

McCulley thus believes that the best interests of the economy are serves by keeping interest rates low and accepting somewhat more inflation than has been regarded as acceptable in the past.

I want to emphasize that I am neither agreeing or disagreeing with him. His notions are somewhat counterintuitive to me but I think this is at least worth thinking about.

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Dick Lepre