The Federal Reserve's policy committee in charge of setting U.S. short-term interest rates meets today in an environment of accelerating turmoil that has been simultaneously afflicting the stock, credit, energy, housing and foreign-exchange markets. If that weren't enough, the Fed will also confront more mundane matters (economic growth and inflation) that are causing the central bank problems independent of the market turmoil. The economy has been growing slower during the past year (1.8 percent) than previously believed, according to recent revisions. Meanwhile, headline consumer-price inflation, which came in at 2.5 percent during 2006, has accelerated to an annualized rate of 5 percent during the first six months of 2007. With the price of oil approaching $80 per barrel, which is nearly $30 above its level early this year, the Fed also needs to worry about the inflationary momentum of soaring energy prices creeping into the non-energy sector.
It has become increasingly clear that the subprime mortgage market isn't the only home-lending sector producing toxic waste throughout the securities markets. Home-buyers with stronger credit are now encountering problems, which are likely to get worse in an environment of falling house prices and stricter loan standards. Nearly $1 trillion in adjustable rate mortgages are scheduled to increase their interest rates before the end of next year, but fewer and fewer households will be able to meet the credit standards to refinance their ARMs into 30-year fixed-rate mortgages.
Problems once thought to be confined to the mortgage markets are now threatening other credit sectors, including junk bonds, leveraged buyouts and emerging markets. In recent years, an unprecedented worldwide glut of liquidity pushed the spreads between risky bonds and U.S. Treasury bonds to their lowest levels in history. Indeed, six weeks ago, in a Wall Street Journal essay forecasting "The Coming Credit Meltdown," Steven Rattner, the New York investment banker who is probably on the short list of most Democratic presidential candidates for a high-level Treasury position, observed: "No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower."
What has been happening in recent weeks is a repricing of risk. The "live grenades" observed by Mr. Rattner have begun to detonate. Junk bonds yielding about 2.5 points above Treasuries were issued and embraced with little regard to risk differential. Now, the spreads between risky debt instruments and U.S. Treasuries are rising and will likely continue to do so. Lenders have belatedly begun to tighten their standards and reckless loan practices are being abandoned.
As former Fed governor Larry Lindsey, who later served as a top economist in the Bush administration, recently argued, "It's important that we have a profit-and-loss economy and that the market does not expect the Fed is going to step in and bail them out when things get excessive." He offered sound advice. "[L]et the market work."
At this stage, there is no need for the Fed to risk its hard-won credibility on the inflation front by opening the spigots.