The Fed’s balancing act

If Wall Street hedge funds and investment banks really believe that a quarter-, half- or even a full-percentage point cut in the Federal Reserve’s target overnight interest rate would somehow turn their portfolios of toxic subprime-mortgage securities into a tradable asset approaching par value, then Wall Street remains as grievously mistaken today as it was when it aggressively marketed these highly risky securities as AAA investments.

That said, it appears Wall Street may soon get its wish. Pressure for the Federal Reserve to lower the federal-funds rate has intensified in recent days. In fact, the Fed itself has contributed to these pressures. On Aug. 17, the central bank’s policy committee revealed that it now “judges that the downside risks to growth have increased appreciably.” The Fed assured the markets that it was “prepared to act as needed to mitigate the adverse effects on the economy,” a clear signal that a cut in the overnight interest rate was forthcoming. Those statements contrasted sharply with the Fed’s Aug. 7 statement. Then, the Fed acknowledged that “the downside risks to growth have increased somewhat” but reported that its “predominant policy concern remains the risk that inflation will fail to moderate as expected.” The Aug. 17 announcement never mentioned inflation.

While we shared the Fed’s previous preoccupation with inflation, we have believed the economy was in more trouble than the Fed acknowledged on Aug. 7. With personal consumption now accounting for more than 70 percent of gross domestic product, we admit to being spooked by the very subpar annualized growth rate of 1.3 percent in consumption during the second quarter. We are also worried that business spending on equipment and software (which is 80 percent of total business investment) was at the same level last quarter as it was five quarters earlier. Yes, exports have increased nearly 7 percent during the past year, but it is hard to get too excited when the trade deficit over the last four quarters totals about $750 billion.

Between Aug. 7 and Aug. 17, what news did we get about inflation? We learned that consumer prices moderated in July, rising only 0.1 percent. However, over the past six months, consumer prices have increased at an annual rate of 4.8 percent, nearly double the 2.5 percent increase during 2006. We also learned that producer prices for finished goods, which measure inflationary pressures at the wholesale level, have soared at an annual rate of 8.7 percent during the last six months. During 2006, producer prices increased 1.1 percent.

In other words, the Fed is confronting a situation that embodies accelerating inflation, potentially rapidly decelerating economic growth and extreme turmoil in the financial markets. If the economy enters a recession, Wall Street may look upon the last month as “the good old days.”