The Fed's Interest Rate Dilemma: Rescue the US Housing Market, or Feed the Poor?

By: Martin_Hutchinson

At their two-day meeting that starts today (Tuesday), U.S. Federal Reserve policymakers will have to grapple with a moral choice that is well beyond the pay grade of central bankers - choosing between the financial stability of U.S. homeowners and world hunger.

That's not an exaggeration. Interest-rate policy normally only affects the world economy at the margin, but it has now been so expansionary for so long that the Fed's interest-rate strategy has turned into a moral dilemma of sorts. In short, the central bank's monetary policy will likely determine whether millions of U.S. homeowners lose their homes or millions of the world's poor starve.

Let me explain…

Expansionist Policies Lead to Market Bubbles

The Federal Reserve has been pursuing an expansionary monetary policy - growing the M3 money supply much faster than Gross Domestic Product (GDP) - since 1995. This has yet to result in U.S. consumer price inflation because a very powerful deflationary force - the introduction of cheap and readily available global communications through the Internet - has counteracted it.

Even though prices of domestically produced goods were increasing, the prices of many goods and services dropped as they became sourced from India (software services, for instance) and China (clothing, for example).

The result has been asset bubbles in both U.S. stocks and then U.S. housing, but without an accompanying big increase in consumer price inflation. Since last September, the Fed has moved to make monetary policy even more expansionary, cutting the benchmark Federal Funds rate six times to bring it down to 2.25% from its starting point at 5.25%, and pumping massive amounts of money into the banking system to bail out the banks that had lost money on subprime loans.

Most experts believe the central bank will cut rates again tomorrow (Wednesday), most likely taking the Fed Funds rate down another quarter point, to an even 2.0%, upon which the central bank will take a rate-reduction breather.

From the point of view of the U.S. housing market, Fed Chairman Ben S. Bernanke should keep cutting interest rates. Low short-term interest rates have a doubly beneficial effect on housing:

• First, low-level short-term rates tend to reduce long-term mortgage rates, while at the same time making banks more profitable. This increases banks' readiness to lend for housing and reduces the interest rate on mortgages, making finance easier to get and cheaper for prospective homebuyers.

• Second, lower interest rates cause inflation. Consumer-price inflation is currently running at an annualized rate of about 4% over the last 12 months, so interest rates at about 3.6% for 10-year Treasuries and 2.25% for the Fed Funds rate are now significantly below the U.S. economy's inflation rate. That means savers are getting an even worse deal than they usually get. It also means inflation is almost bound to accelerate: By definition, if borrowing costs are actually less than zero, people will find ways to borrow and then will waste the money they have borrowed.

The bottom line : Inflation is likely to rise rapidly towards the 10% level in the months to come .

The Fed's Inflation-Fueled Rescue Plan

In most quarters, inflation is viewed as a four-letter word. But in a housing market where home prices are locked in a downward spiral, inflation is actually very good. For instance, should inflation spike to 15% and stay there for all of 2009 - while the U.S. economy remained in decent shape - then wages and prices could be expected to increase by 15% in 2009.

Additionally, the dollar would drop in value against other currencies that did not experience this burst of inflation. That would make housing relatively cheaper both for U.S. homebuyers (house prices would be a smaller multiple of earnings) and for foreigners (fewer European euros, Japanese yen or Chinese Renminbi needed to buy U.S. houses). The decline in housing prices would stop - and probably reverse - and the tsunami of mortgage foreclosures also would slow. The reason: Home mortgages would cease entering the "negative equity" situation in which it is cheaper for borrowers to walk away from both their home and mortgage than to keep making the payments.

If we're only considering the housing market, Bernanke should lower interest rates as fast as possible. It will cause inflation , but he may well believe that a further series of home-price declines would cause so many problems in the home-mortgage market that moderate inflation is preferable.

Unfortunately, we don't live in an economic vacuum, and Bernanke and his fellow Fed policymakers have much more to consider than just the travails of the U.S. homeowner.

You see, in addition to U.S. inflation and housing, Bernanke's monetary policy has affected the world commodity and energy markets - and in a huge way. That's why oil is now five times more expensive than it was in 2002, and is likely headed higher , still, before consumers get a reprieve.

But it was the rate-cutting campaign the Fed embarked upon last September that's inflicted the real damage. Fed policymakers fired their first shot at the Fed Funds rate on Sept. 18, when it took short-term rates from 5.25% to 4.75%. On that day, oil closed at $82 per barrel, gold at $770 per ounce and the Reuters-CRB Index (CCI) of commodity prices was at 435. The flood of money poured into the system by the Fed and other central banks in the last seven months has had the anticipated impact: As I write, oil is at $118, gold is at $890 and the CCI Index has reached 544.

Bernanke's low interest rates, and the equivalently low interest rates in many other countries of the world, affect commodity prices in three ways:

• First, they cause economic activity to increase more rapidly than would normally be possible. In the long run, this would produce benefits (if it were not succeeded by a period of above-normal rates to quell inflation). In the short run, it causes consumption to outrun production, producing shortages.

• Second, low interest rates increase the amount of liquidity in world markets. For proof, just look at one statistic - world foreign exchange reserves have increased by nearly 17% annually over the past 10 years , double the growth rate of global GDP. That liquidity causes prices to rise, especially in energy and commodities markets, where a freely fluctuating market exists.

• Third, low interest rates encourage the creation and expansion of speculative funds (such as hedge funds), which seek to capitalize on escalating commodity prices, which has the effect of sending overall prices even higher still.

Bail Out Homeowners (or) Feed the Poor

While Americans consume only moderate quantities of raw commodities as a percentage of total consumption (there is little, if any, iron ore in an Apple Inc. ( AAPL ) iPod, for instance), for poor people in the Third World commodities still account for the bulk of their budget. While increases in energy and metals prices simply raise the cost of living, food-price spikes are much more serious, since they directly and significantly erode the living standards of the world's poor.

Still more disturbing is the fact that the recent surge in food prices (which has been extreme, rice alone having trebled in price in the last year) has caused the beginnings of a breakdown in the world's free trading system in food. Rice exporters such as Egypt, Indonesia and Vietnam are restricting, or even prohibiting, the export of certain kinds of rice, moves they've made to try and keep prices of that commodity down in their home markets.

Since many poor countries such as India also subsidize basic food prices to limit urban unrest, national budgets are being thrown out of kilter.

At the margin, for the very poorest people in the least competently run countries, the result of this food-price surge is likely to be starvation.

New crop plantings will alleviate the problem within a year, but for many, that will be too late: You can defer an automobile purchase until next year, but you can't stop eating.

Bernanke no doubt hopes that he can keep interest rates low and thereby stimulate the U.S. economy and solve the housing problem, wringing out any inflationary results by pushing rates higher once housing has stabilized and the U.S. market has moved back onto a growth track. That appears excessively optimistic. A prolonged period of low interest rates will perpetuate the bubbles in energy and commodities, which will have two effects.

In the United States, it will firmly establish an inflation level of 10% or more, which will require a wrenchingly difficult recession to emerge from, as it did in 1979-82, thanks to a managerial miracle by then-Fed Chairman Paul Volcker.

But in poorer countries, a long run of low interest rates will not only cause inflation and hardship, it will bring starvation as food prices soar well beyond the means of the poor. Hoarding will result, until finally all the world's food-market mechanisms end up collapsing.

So if the central bank does cut interest rates tomorrow afternoon, think twice before you cheer.

News and Related Story Links :

• Money Morning : Fed Will Grab Headlines This Week With "Last Hurrah" Interest-Rate Cut; Key GDP Stats Also Anticipated .
• Money Morning Research Report : Three Ways to Profit in the Face of Surging Inflation .
• MarketWatch.com : The Fed: Fed rate cut not a sure thing .
• Money Morning Investment Research : Three Ways to Play Money Morning's Prediction That Oil Prices Will Reach $187 a Barrel .
• Money Morning Investment Analysis : With its Jump to a Record $1.68 Trillion, China's Foreign Currency Reserves Spawn Major Inflationary Fears .
• Money Morning Investment Research : Six Ways to Protect Yourself - and Profit - From a Global Food Crisis That's Here to Stay .

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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