Someone needs to give Fed Chairman Ben Bernanke a wake-up call. The Dow fell today by 358 points in the wake of a sliding dollar and oil soaring past the $140/barrel level. [Oil closed at $139.64/barrel, an all-time high.] It may indeed validate the prediction of $150/barrel by the 4th of July.

All of this in the one-day aftermath of the decision by the Fed (with Richard Fisher dissenting) to hold the Fed funds rate at 2.0%.

A few pointed comments from an editorial in The Wall Street Journal today:

The Federal Reserve stayed true to its recent news leaks yesterday and held its target interest rate at 2%. In lieu of action, Chairman Ben Bernanke and his mates decided merely to talk tougher about inflation, signaling that they may lack the will to tighten money in an election year.

....the Fed continues to run a highly accomodative monetary policy. The consumer price index is rising at a rate roughly double the fed funds rate, and the CPI is a lagging indicator. Producer prices in May were up 7.2% on an annual basis, and that's before soaring oil and food prices have made their way through the economy. The dollar remains weak against gold, oil, the euro, you name it.

Every American who drives or shops for groceries understands this, except at the Fed, where they bow before something called 'core inflation'. This is a way of measuring prices without including food and energy, and so we are supposed to take comfort that 'core inflation' is rising at only a 2.3% annual rate. Yet it is the Fed-induced price spike in food and energy since last August that has Americans in an uproar and Congress in a panic that may yet produce major policy blunders.

But don't worry: Yesterday's Fed statement averred that it "expects inflation to moderate later this year and next year." That's good to know, though the Fed Governors will have to do some evangelizing because this isn't what the public thinks. According to the Consumer Board's June survey of consumer sentiment, Americans believe inflation over the next 12 months will be 7.7%. That's up from 6.8% in April, 5.4% in February, 5% last September, and the highest in the last 20 years.

It was only a couple of months ago that Frederic Mishkin, Donald Kohn and other Fed Governors were asserting that "inflationary expectations" were "anchored." In fact, those expectations are soaring, which means they will soon begin to show up in wage demands and price increases throughout the economy. The more deeply those expectations become embedded, the harder they are to change and the more the Fed will have to tighten money to uproot them.

Meanwhile, inflation continues to rise around the world, especially in what the Paul Volcker Fed understood was the 'dollar bloc'. Headlines like this one have become routine: "Chinese agree [to] 96% rise in iron ore prices." Mexico's CPI has leapt above 5%, and Brazil's overall inflation rate is nearly 6%.

All of this is evidence that the Bernanke Fed has failed in its main responsibility of maintaining price stability and a stable dollar. In its defense, the Governors would say they have acted to prevent the credit crisis from becoming a global recession. But in the process they have ignited a global spike in commodity prices that amounts to a huge tax increase on much of the world. It is crushing the airlines, may well break the U.S. car companies that rely on SUVs for their profits, and is sapping the purchasing power of the American middle class.

It has been an historic blunder, and the damage will only increase the longer the Fed takes to correct it.

LeRoy: The Bernanke Fed appears to have forgotten the lessons of the 1970s inflation. They appear to have forgotten how difficult it is to return inflationary expectations to more normal levels once workers and consumers become inured to rapidly rising prices. [It took the very painful recession of 1980-1982 to bring that about.] The quoted figure of 7.7% expected inflation was, remember, before the shocking oil price increase of today. And why would the Fed expect inflation to 'moderate' over the rest of this year and the next year, given the extraordinary pace of money creation over the past ten months?

Is it because they are expecting, in fact, a very serious economic downturn to begin in the next few months? That is not what they say, of course. At least not in public.

It would be interesting to be a fly on the wall in the halls of the Federal Reserve, to hear what the Governors are saying to each other when they are not in the meetings where minutes are recorded, and later released for public consumption.

I bet they are having some interesting conversations these days.

Perhaps that is an understatement.

Just a little note. If inflation is indeed to start translating into wage and price pressures then the economy will have to quit shedding jobs, something it isn't in any hurry to do. It's hard to ask for higher wages when you're out of work, and it's hard to increase prices for the things you are trying to sell when your customers are out of work.

The underlying and probably rather malignent weakness of the U.S. economy will continue to undermine the value of the dollar and keep imports expensive no matter what the Fed does, they are in a position of having to swim upstream here.

Foreclosures are a powerful deflationary force. I think Ben is wise to avoid overcorrecting a causing a depression.

Foreclosures jumped another 7% in may. That means delfationary pressures are still building. The price of oil, meanwhile, is nearing some important thresholds.

I think the next president is going to guarantee a minimum price for oil. Yup, a *minimum*.

What the fuck? wouldn't a maximum price be better? Well, there's still some yahoos out there who think oil is in some bubble and will drop to $70 barrel. The next president can put this silly rumor to rest by setting a price floor, like at, say $80/barrel, and start adding capacity to/ reducing the oil in the SPR. If oil drops to $80, then start filling the SPR back up.

A guarenteed price floor will encourage FT plants, TDP plants, high cost exploration, et cetera.

Of course, OPEC will have to agree to it, but since OPEC is pumping pretty much at capacity, they won't give a damn. In fact, they'll be just as re-assured by the price floor as US companies. They are deathly afraid of a repeat of the 90's with $11/barrel oil, and frankly I don't blame them. I don't agree with them, but it's hard to ignore history altogether no matter how compelling the facts.

Gingham says: If inflation is indeed to start translating into wage and price pressures then the economy will have to quit shedding jobs, something it isn't in any hurry to do. It's hard to ask for higher wages when you're out of work, and it's hard to increase prices for the things you are trying to sell when your customers are out of work.

LeRoy: Sounds reasonable, and this indeed was the conventional view in economics for a long time. In the 1950s and 1960s almost everyone thought that there was an inverse relationship between wage inflation and unemployment, and for precisely the reasons you state. The graphical depiction of that relationship was known as the Phillips Curve. But then came the 1970s. And stagflation. When prices (or inflation) and unemployment were rising at the same time. That shocked a lot of people back in the 1970s. Some had even said that such a combination was impossible.

Obviously not. What happened in the 1970s was that the entire Phillips Curve shifted to the right, making the trade-off between unemployment and inflation much more unpleasant. And what caused this was an embedded rise in the amount of inflation that people expected. Which was, in turn, caused by the very loose monetary policy of most of the 1970s, and by some other macroeconomic policy blunders as well.

We are playing with fire here, making the same mistakes as we made back in the late 1960s and for most of the 1970s. Stagflation is rearing its ugly head again. The most serious inflationary pressures are being felt in energy and food. [Obvious, no?] Well, even unemployed people have to buy food...and they may have to buy gas, if only to get around to look for a job. [I went through that myself, back in 2000, when fortunately for me, gas was very cheap.] In other words, you can have rapid inflation in food and energy prices, in particular, even when unemployment is rising, because the demand for these products is so inelastic.

That is why the Fed's reliance on the so-called 'core inflation' rate is so objectionable. As one person remarked, core inflation is inflation with all the inflation stripped out.

Gingham again: The underlying and probably rather malignent weakness of the U.S. economy will continue to undermine the value of the dollar and keep imports expensive no matter what the Fed does, they are in a position of having to swim upstream here.

LeRoy: One of the major causes of the 'malignant weakness' of the U.S. economy is our weak dollar policy, maintained by very low interest rates (especially compared to Europe, where they evidently take inflation more seriously). Another major cause is the almost complete lack of an incentive to save, caused again by our interest rates being lower than the rate of inflation, meaning a negative real interest rate. Both of these are things that can only be corrected by higher interest rates. It would be a better analogy to say that right now, the Fed is swimming downstream, with its easy money policy, not recognizing that there is a very dangerous waterfall right up ahead.

They'd better start swimming upstream, right away, just as hard as they can.

Despite the three years on negative real growth in the seventies real growth ran well over 5% for most of the decade. Point being the economy had a lot more steam then than it does now, when real growth is hasn't gone over 4% since 2000. So I am not sure the wage pressures will be the same as they were then. In fairness, however, the unemployment/participation rates were also less favorable then.

What caused this economic downturn? Mainly the freezing of credit and the destruction of wealth based in the housing sector. Because of this the rate cuts the Fed pursued had limited effect. No matter how much cash they through around the markets had/have no stomach for risk. In this light they may as well raise rates since they aren't having the desired effect anyway. Not only are they limited in what they can do help the weak dollar because of the state of the economy, (in my opinion), they are also limited in what they can do to help push the economy along because of the state of credit markets.

I'm not so sure the rate cuts by the fed have had a "limited" effect. It may well be the rate cuts prevented some foreclosures, and reduced bank losses on others, preventing a banking collapse and massive unemployment.

I guess my example is this: You have a lucky flask, and get shot at. The lucky flask deflects the single bullet, and you're uninjured. Then you put on a kevlar vest and someone shoots you with a machine gun. You get bruised and end up in the hospital.

With the lucky flask, you got no injuries. With the kevlar vest, you got bruised, but only because the firepower you were up against was so much more than what the lucky flask was used against. I think those fed cuts may have been kevlar to hold up against some very heavy firepower.

Agreed, insofar as damage control is concerned. My point was that while damage control has been achieved stimulating the economy to the point of vitality has not been achieved. That is the limit I am speaking of. In the recent past such slashing of rates, such injection of capital would have created a surge of activity, but now unless we want to say commodities are the new bubble, following the stock market of the 90's and then the housing market that surge has not occured.

I also agree on the "heavy firepower" statement. While we have some idea of how close the economy came to a complete meltdown I think it will be up to history to point out, once this has run it's course, that the catastrophe could have been much worse than it was. Now whether or not the economy was saved, or merely put on life support, allowing festering problems to remain and show up again later, also remains to be seen.

I do not believe cedit can re-ignite an economy, unless there'ssomething new and life-changing to spend the borrowed money on.

The early 1980's recession was ended thanks to the introduction of, and rapid improvements to, the PC.

Likewise, the internet fueled the boom of the 90's.

At this time, I don't see how the next few years can see anything but an alternative energy boom. It would be the perfect place to dump our unemployed, and it would solve the most pressing concern of high gas prices.

You know it's something we need to do, and it will create economic activity, it could also position us to be competitive in a new industry with global marketing potential, but the problem is that at this point it is still a net minus economically. Nothing will give us the energy bang for the buck that oil has. It's not like the IT thing where you not only saw economic acitivity around it's adoption but you also saw productivity increases, alternative energy at this point still has a negative impact on the productivity of capital.

Sorry got called away there for a sec. I don'tthink you can say that easing credit doesn't increase economic activity also. You might want to argue by how much, but not simply whether it does or not. This would be clearer if the asset bubbles created recently by easy credit had caused the wealth they created to be spent on goods with more domestic content. The problem is, of course, the accumulation of debt that it entails. It is easy to see where that has gotten us. So there are real negatives, bubbles, debt accumulation, but easy credit will increase economic activity.

We might also want to makethe distinction between easy credit and expansive monetary policy. Which work hand in hand. But for instance businesses get very little of their capital from bank loans, but if the cost of capital is less they will be much more likely to make ceratin investment decisions. It all coming down to whether the return on that investment is better or worse than what one would get by parking the money, which becomes more attractive in a tight money scenario.

Energy prices, even for electricity, are rising. The polysilicon shortage will end by 2010 and then solar prices will fall.

I think 2010 will be the year that solar beats coal for cost of energy production, and if not, it won't be far off.

Meanwhile, I have hoping for fringe bennies, like parking in the shade/out of the rain, under solar panels.

Several points:

1. The stock market rarely tanks with a tanking dollar. It happened during much of 2002, but not after March 2003 until last October to March of this year. Since March the dollar has been rising as the stock market first rallied then tanked. I would say that the market decline of 2002 was the climax to the 2000-3 bear market, and so was fore-ordained. The October, 2007 to March, 2008 decline was simply a correction from the absurd euphoria of the 2006-7 bull (itself the climax to the whole rally from 2003) plus some panic from the credit crunch. Now reality is starting to settle in and people are getting more pessimistic about a quick turnaround.

Similarly, you seldom get a market bull with a rising dollar, although this combination is more common than the falling market/falling dollar. Thus, the late 1990s and more recently most of 2005 witnessed both a rising market and a rising dollar.

2. I agree about the absurdity of using 'core inflation' when food and energy are making sustained price rises, as they have been doing.

3. We have argued about the reality of inflation/deflation over many threads. We can agree that during the early 00's we saw inflation in assets (equities, homes) and deflation in consumer goods. But oil was rising from 2002, and had quintupled in price by late 2006, so food, energy, and some consumer goods were bound to rise. The Fed started raising rates in mid-2004 from a very low base, and only in baby steps (25 bp.). They were behind the curve. But the 5.25% they ended up with was unsustainable and was sufficient to pop the housing bubble. Our economy is so weak and leveraged that we can't stomach interest rates of 5%, which is a conservative estimate of CPI inflation. I think this was G_D's main point.

4. As to money supply rates, I have read recently that M2 has hardly grown at all over the past year, and bank loans have contracted by 5% in the last year. Hardly inflationary, if you take money and credit growth to be synonymous with inflation. M3 is a different matter, but do we really know what it's running lately? In any event, I agree with the Fed that monetary inflation will indeed moderate with the great credit unwind.

5. I think you are very probably right on the following: Is it because they are expecting, in fact, a very serious economic downturn to begin in the next few months? That is not what they say, of course. At least not in public.

I think they wish not to alarm the big players, and are hoping against hope that the boat will turn around without capsizing. It is a balancing act, and the deflation from the credit unwind is about balanced by the inflation from food, energy, and imports. Officially, the unemployment rate has climbed by about 1 percent and the CPI inflation a bit less, so they're probably still more worried about a weak economy.

Regrettably, a lot of this shit is just bad karma from Bush's first term, and unavoidable.

And I think it is a valid point, though I can see the holes in it. We are so far below what would be condsidered to be a neutral rate that to take it high enough to make a difference would be hard for the conomy to swallow. The other way of looking at it is that, of course, currency markets work on a comparison basis. It doesn't matter where your currency is at it matters where it is at in relation to other currencies. In this light the dollar is currently alone in suffering the pains of the "solvency" crisis to the degree it is. So while it has dropped and it's economy has suffered other currencies are either operating in a high gear or other central banks have been in a position to place themselves more strongly with anti inflation policy. Point being for the dollar to catch up and appreciate much in relation to other currencies it will require more than a small adjustment.

Now the big hole in this is that we are working under the assumption of the old punch bowl theory. Just when the party gets going the Fed takes the punch bowl away, it tightens to monetray policy, slows demand, and cools the economy. But as you allude to the markets have already done this by tightening lending standards and having a dry up of capital via the downgrading of assets. While the Fed says 2% the markets act like the Fed is saying 8%. So the argument that since dollar demoninated commodities are strangling the economy because of the inflation they are experiencing, and that increasing the value of the dollar will only help the economy by cooling inflation does hold some water, since credit markets are so tight anyway, increasing the rate wont make that much difference. Still what the Fed is trying to do is minimize that tightening of the credit markets, we can only speculate how much a tightening of Fed policy will have on causing the economy to not only slow down but grind to a complete halt. It may be best to say the economy had absorbed the increase in commodity prices, and that the goal shouldn't be to try to drop them back, but simply stabalize them near the level they are at.

We must also be wary of popping the commodities bubble. So much wealth has gone down the toilet over the last few years that some funds have become dagerously exposed to the commodities markets. Popping the commodities bubble may only make the "solvency", (this is about more than subprime now), crisis that much worse.

Now here is an off the wall idea. I have over the past couple years here complained often about the currency markets and the need top stabalize the functioning of the gloabl economy by having a new Bretton Woods. I have also readily admitted how unrealistic that is. But there is a commonly used tool that accomplishes much the same. Pegging currencies. This is a tool used mainly by developing economies to increase faith in the stability of their currencies while they grow. But what if major economies also adopted the tool? I imagine there would be great resistance from a national pride standpoint, but I do think it's an interesting thought which deserves some level of consideration.