The Fed's Rate Cuts Aimed at Reviving Goldilocks May Stir the Inflation Bear

The aggressive moves to stave off a cooling economy may have dire consequences down the road.
By David A. Gaffen ,

The early version of the Goldilocks fairy tale had a decidedly gruesome, pro-bear ending in which the fussy maiden meets her death as a snack for the bear family. A similarly fidgety

Federal Reserve could be doing the same thing to the once invincible "Goldilocks" economy.

The Fed has been given the lion's share of credit for maintaining this expansion for longer than anyone expected. But these days, the economic situation is far from "just right." A number of skeptics are concerned the Fed's aggressive rate cuts aimed at averting an inevitable "too cold" economy will yield a more treacherous "too hot" economy not far down the road.

Wednesday, the Fed eased off the gas,

opting to cut rates by 25 basis points instead of the 50 basis points some expected. The move comes after five half-percentage point cuts -- with the

fed funds rate now at 3.75%, from 6.5% at the beginning of the year.

Some economists say the Fed's cuts, while understandable, can't reverse an economic downturn without other consequences. "The great American public is asking the Fed to do something it cannot do," said Andrew Smithers, president of

Smithers & Co.

in London.

The old college try may have dire results. Fueling demand by flooding the system with money may bring about an inflation problem that can't be whisked away with more rate moves. If growth remains shaky and inflation rises, the result could be a worse recession than the one that we may or may not be in now.

Initially, for the next several months, inflation is likely to abate in response to declining pressure on the labor market and production. When demand rebounds, companies will feel less squeezed, thanks to the Fed's efforts.

Initially this will look good: Corporate profits, currently being crushed as if in a vise, will rebound, shoring up spending. But ultimately their higher costs will necessitate price increases in goods because productivity isn't likely to be the offsetting factor that it was in the past few years.

Greenspan's (and Hobson's) Choice

With the economy in this sorry state, some say there's no option but to inflate the economy. To paraphrase

Churchill

, the Fed's solution is the worst choice, except for all the other choices. Where the mistakes lie, then, is a few years ago, when the Fed allowed for the formation of an asset bubble, one that

Alan Greenspan in 1996 memorably termed

"irrational exuberance" (and then seemingly forgot about that assessment for years following).

Thanks to easy policy, financing from banks and the bond market -- and later the equity market -- ballooned, resulting in a historic explosion in asset values that's still deflating. With this grew the notion that the Fed could get the markets out of any jam -- buffering bad investment decisions. In short, printing money.

"All the world's economic problems would be solved if printing money created wealth," says Paul Kasriel, chief U.S. economist at

Northern Trust

. "It's counterfeit money that creates demand in the short run and creates higher inflation with a longer lag."

Still, that's what Greenspan and his cohorts have been doing to boost demand. The

money supply has exploded in recent months as a result.

This supply may help corporations and may alleviate some of the sluggish economic growth the country is mired in at this point. What increased availability of funds also creates, unfortunately, is inflation, and this time it's not likely to be as neatly contained in financial assets as in 1999, when all excess funds seemed to go directly into shares of the likes of

VerticalNet

(VERT)

.

For a period of a few years, companies found they couldn't -- and didn't need to -- raise prices. A confluence of factors, such as improved productivity, falling energy, technology and basic materials prices, the Asian financial crisis and declining medical costs boosted profits and allowed for massive reinvestment.

Stocks soared; excess money was invested in those stocks, which did wonders for people for a long time. The Fed wouldn't have needed to attack the stock market, just to recognize the cheap money underlying it.

"One would hope, at least, they would have stamped on the asset bubble," says Smithers. "This might have produced a small recession in 1996, rather than a very big one that appears to be threatened at the moment."

Money begat money, rallies begat rallies and then the Fed

cut

rates in 1998, exacerbating the situation.

Nasdaq

5000 was the result.

An Unhappy Ending

Those Goldilocks factors largely have disappeared. It's no surprise that companies are cutting back spending as they deal with rising fixed costs and weighty debt burdens.

The market wants the golden period back. It's not going to get it, but it's still prostrating itself in front of the Fed's home, the Marriner S. Eccles Building, praying to avoid a recession. Higher costs will eventually have to be passed on to consumers, who will need more ways to pay for it. In the previous environment, they were happy to borrow money.

But if the Fed has to raise rates to combat rising inflation, borrowing won't look so attractive to anyone. The corporate debt burden is near an all-time high, and households pay more of their disposable income to debt service than they have since 1986. Spending, for that matter, won't be so attractive either.

The worry the skeptics have is not of recession. The concern is that postponing recession by printing money will only worsen it by exacerbating existing structural problems. And when the recession does happen, it could end up particularly nasty.

The Fed folks may have no other choice. They had one a few years ago, and took a pass.

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