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Playing Poker With The Fed

The Fed gets it. It's just that there isn't much they can do about it.

The end of July saw the first announcement of the second quarter's Gross Domestic Product (GDP) number, closely followed by a meeting of the Federal Reserve's Federal Open Market Committee. The outcome? Expect low savings account rates to continue for quite some time. More broadly, it remains unclear just what will snap the economy out of its funk.

Playing a weak hand

The Fed is like a poker player who has been dealt a weak hand. It's easy to criticize a losing player, but when one looks at the cards, it's hard to say exactly what should be done differently.

The latest setback for the Fed -- and for the economy in general -- came in the form of that second-quarter GDP report. According to the Bureau of Economic Analysis, GDP growth slipped to 1.5 percent in the second quarter, following an already-disappointing 2.0 percent in the first quarter. Clearly, the trend is going in the wrong direction.

The primary card the Fed has to play to stimulate the economy is to lower interest rates. It has taken extraordinary measures to do this, with limited results. The fundamental problem is that Americans are already awash in debt. Years of low savings rates sent Americans into the Great Recession with record high debt levels. After a brief flirtation with paying down debt in the first couple years after the recession, Americans resumed piling up debt, and debt levels reached a new high in the second quarter of 2012.

If low interest rates were the Fed's ace in the hole, that ace has turned into a joker. Low interest rates can't stimulate much in the way of borrowing, because credit lines are largely tapped out. However, the Fed can't afford to back away from its low interest rate stance, because the added debt burden would overwhelm borrowers.

Wild cards

As if the debt dynamic were not challenging enough, there are some wild cards which can act either for or against what the Fed is trying to accomplish:
  1. Inflation. Inflation has cooperated in recent months, but a new bout of rising prices would further complicate the Fed's job. Inflation could easily accelerate again if the drought drives up food prices or there is another oil scare.
  2. Europe. Europe's troubles represent uncertainty and the prospect of slower U.S. exports. A bold solution in Europe would be a big help to the U.S. as well.
  3. Emerging markets. Large emerging economies such as China, Brazil and India have the potential to be the drivers of global growth, but lately they seem to have been sucked into the global malaise.

It takes skill to play poker, but ultimately success or failure lies in the cards. The Fed is going to need some of these wild cards to turn in its favor in order to win this hand.

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