More Fed Watching, The Dilemma of August 8

In the post of July 5, After The June Hikes, What Next?, we wrote "unless the second quarter GDP data clearly show a significant slowdown in growth (say below 3%), the balance of risks, in my view, still suggests further 25 basis-point rises in policy rates by the Fed."

In the post of May 25, Inflation, Interest Rates, And Short-Term Market View, we wrote “We may be headed for a period of stagflation, or at least slowing growth and stubborn inflation in the next six months, possibly very slow growth or a mild recession in 2007”.

In the event, the 2^nd quarter GDP growth data came in at 2.5%, apparently lowering the probability of an August hike, but even core inflation, the narrow gauge that the Fed officially touts as its most watched (the so-called personal consumption expenditure minus food and energy), accelerated to 2.9%.

The dollar weakened against the euro, apparently because of the higher probability of a pause in the US and expectations of further hikes in the eurozone. The stock market rallied, also on renewed expectations of a pause, or even an end to the tightening cycle, and the bond market rallied, in part on expectations that a slowdown will, in and of itself, help to cool inflation.

But again, the dollar weakened, the yield curve is noticeably inverted, inflation is stubborn, and consumers, along with the government, are still heavily indebted.

The dilemma the Fed faces is, on the one hand, to what extent to i) recognize real inflation – i.e. the rise in prices of what real human beings actually need, like food, energy, housing, healthcare, and education –, risking what may prove to be a sharp, but healthy, slowdown or recession, and ii) prop up the dollar, or, on the other hand, to prop up the stock market and possibly the real estate market, rolling over, or at least sustaining, the asset price bubble in an attempt to keep consumers feeling good while the government pursues overseas energy wars.

The purported high productivity of the US economy alone is not enough to solve this dilemma. At some point, this productivity must be put to the test in the face of high levels of international competition and the ongoing energy war.