- The Washington Times - Tuesday, April 19, 2005

Last week’s stock market meltdown, with major indexes falling 3 percent, is only the latest indication of the economy’s fragile condition. One is even starting to hear the first whispers of the “R” word (recession). Though I think such expectations are premature, the financial sector is under growing strain that could burst and spill over into the real economy suddenly and without warning.

The basic problem is simple: the Federal Reserve is tightening monetary policy. Historically, this has preceded every major economic slowdown or significant market correction. For example, the Fed began tightening in mid-1999, the stock market peaked in early 2000, and clear signs of a recession were evident by the fall of 2000.

The Fed’s current cycle of tightening began in June 2004, so it is not surprising we begin to see the first signs of an effect. Since then, the Fed has almost tripled the federal funds interest rate from 1 percent to 23/4 percent. And there is every reason to believe the Fed will continue tightening for the foreseeable future.

The reason is the Fed concern that inflation may re-emerge. All the early warning signs are there: The dollar has been weak on foreign exchange markets, commodities like oil are rising rapidly, housing prices continue upward at an amazing rate and the growth of productivity has fallen significantly.

These factors, except for the skyrocketing gasoline price, have yet to seriously affect consumers. But it is only a matter of time before they work through the system and start raising the Consumer Price Index.

The Fed wants to nip this in the bud before inflationary psychology sets in. When that happens, inflation tends to feed on itself as workers ask for extra pay to compensate for expected inflation and lenders start tacking an inflation premium onto interest rates. Then it becomes almost impossible to bring inflation down without a recession.

The Fed must move gingerly, however, because monetary tightening creates potentially very dangerous strains in financial markets. One reason: Many financial institutions have been making easy money borrowing short and lending long. As long as the yield curve slopes upward, this works. But as the Fed pushes up short rates, the yield curve begins flattening, which can put financial institutions into a bind if they have not been careful enough about hedging themselves.

The greatest danger lies is with Fannie Mae and Freddie Mac, the two giant government mortgage lenders. Their portfolios are now so large — in the trillions of dollars — that even their tiniest mistake could roil markets. Evidence some Fannie Mae managers may have manipulated its finances for personal gain is enough to cause worry about what else may be going on there. That is one reason Congress and the administration have stepped up oversight of Fannie and Freddie.

Another source of financial markets concern is the impending retirement of Alan Greenspan as Fed chairman. He has served in this position nearly 20 years. An entire generation of bankers and bond traders have never known anyone else in this critical post in their professional lives. It is unknown who will replace him. But even with an excellent choice, there is bound to be some transitional financial unrest.

Lastly, the dreaded “twin deficits” loom over financial markets. Huge budget and current account deficits mean vast capital flows are needed to keep them funded. So far, this has gone well, largely because China has been so accommodating about financing — effectively financing their exports by buying large quantities of U.S. Treasury securities with their export earnings.

But now the U.S. strongly pressures China to stop doing so and allow its currency to rise against the dollar. It is hoped this will reduce China’s production advantage in dollar terms and bring down the bilateral trade deficit. However, the cost to the U.S. economy could be greater than the potential gain.

At least in the short run, any scale-back in China’s buying of Treasury securities might cause interest rates to spike very quickly. This could prick the housing bubble and bring down home prices, eroding personal wealth and squeezing those with floating rate mortgages.

We can hope this can all be managed smoothly and without either a recession or a market break. But it will take great skill and luck to avoid both.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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