While nearly everyone seems convinced that the economy is improving and buy-the-dip is the right strategy, the Fed is having increasing concerns about what to do if reflation does not take hold.

The Wall Street Journal discusses “What if?” scenarios in Fed Weighs Growth Risks.

Federal Reserve officials are beginning to debate quietly what steps they might take if the recovery surprisingly falters or if the inflation rate falls much more.

Fed officials, who meet next week to survey the state of the economy, believe a durable recovery is on track and their next move—though a ways off—will be to tighten credit, not ease it further. Fed Chairman Ben Bernanke has played down the risk of a double-dip recession and signaled guarded confidence in the recovery.

But behind-the-scenes discussions at the meeting could include precautionary talk about what happens if the economy doesn’t perform as well as expected.

“If events in Europe evolve so that they have a more severe and broad impact on financial markets, then the scope of the problems for the U.S. could be magnified,” Charles Evans, president of the Federal Reserve Bank of Chicago, said in a speech last week.

Brian Sack, the head of the New York Fed’s powerful markets group, has talked about “two-sided” risks to the economy—in other words, the risk that growth and inflation could turn out to be lower than expected, as well as higher.

“The European sovereign-debt situation is serious, and there are many unanswered questions about how events will unfold,” James Bullard, St. Louis Fed president, said in Tokyo on Monday.

Officials don’t rule out the possibility that markets could settle and the economy could produce a few months of strong job growth and solid consumer spending and business investment.

But there are other scenarios: if the recovery falters, or if inflation slows much further and a threat arises of deflation, a debilitating fall in prices across the economy. In such cases, there would be a few avenues the Fed could take.

One is asset purchases. During the financial crisis, the Fed purchased $1.25 trillion in mortgage-backed securities on top of buying debt issues by Fannie Mae, Freddie Mac and the U.S. Treasury. Mr. Bernanke has said the steps helped to lower long-term interest rates, including rates on mortgages.

In any case, a new report by the Federal Reserve Bank of San Francisco, based on projections for inflation and unemployment, suggests that the Fed may not need to raise short-term interest rates to curb growth or inflation until early 2012, later than is commonly expected on Wall Street.

The report cites a rule of thumb that the Fed tends to lower the federal-funds rate by 1.3 percentage points if inflation falls by one percentage point and by almost two percentage points if the unemployment rate rises by one percentage point.

Based on that rule, the federal-funds rate—now near zero—would be minus 2.9% under today’s conditions and wouldn’t need to move higher until the first half of 2012, according to San Francisco Fed economist Glenn Rudebusch. The analysis factors in the stimulus the Fed has provided with its mortgage purchases.

“It seems likely that the Fed’s exit from the current accommodative stance of monetary policy will take a significant period of time,” the report said.

Risks to Growth All on Downside

The reality is reflation has already failed and other than unsustainable government spending (and massive increases in public debt), the US economy would still be in recession.

Looking ahead, the risks to growth are all on the downside. Here are some of them.

  • China overheats and has to step on the economic brakes
  • Spain or Italy need Euro bailouts
  • Property bubbles in China, Canada, Australia pop.
  • Austerity measures throw the Eurozone back in recession
  • Huge public worker layoffs in the US
  • US housing demand weakens further, housing prices slip, construction dips, and inventory rises from already high levels
  • US unemployment starts to rise
  • UK heads bank in recession
  • Congress starts huge trade wars with China by labeling China a currency manipulator and employs large punitive tariffs

I expect everyone of those to happen with the possible exception of labeling China a currency manipulator. Thus, this is not a case of what the Fed will do “if” the recovery fails, but rather what the Fed will do “when” the recovery fails.

Bear in mind that the only semblance of economic recovery is from government spending, nearly all of it wasted or taking from future demand, thus the reflation efforts have already failed.

Finally, given an expected dramatic shift in Congress this November coupled with increasing worry over deficits and public anger over bailouts to date, reflation round two will play out much differently than did round one.

Mike “Mish” Shedlock
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