Home >> United States & Canada >> Economics & Trade

     Email   Print 

Tough Choices for Bernanke

Prof. Peter Morici - 9/26/2007

The Fed is in a tough box. Vital signs--housing sales, new home construction, retail sales, and jobs creation--all indicate slower growth and the risk of a recession. Cutting interest rates is a necessary but limited policy option for two sets of reasons.

First, lower interest rates will help free up the market for commercial paper and high quality corporate bonds, and help borrowers with adjustable rate mortgages that face rate adjustments in the next few months. However, the recent interest rate cuts will not do much to lower rates on 30 year conventional mortgages, will not much help resurrect the market for jumbo mortgages--those above the $417,000 that do not qualify for Fannie May and Freddie Mac underwriting--and will not help homeowners in default whose home values have plunged below their mortgage balances or who simply could not make the payments on a refinanced, long-term mortgage. The most significant thing the federal government could to boost the housing market would be to help reconstruct the market for jumbo mortgages to credit worthy borrowers by significantly and quickly raising the $417,000 ceiling. For ideological reasons, Ben Bernanke and Henry Paulson are resisting such a move.

Second, the huge U.S. trade deficit has slowed U.S. productivity and attainable GDP growth by one percentage point a year. Coupled with rising oil prices, the trade deficit has greatly raised the risk of inflation the Federal Reserve must address. Although the U.S. dollar has fallen against major currencies, oil is still priced in dollars and the Chinese yuan remains essentially pegged against the dollar. Oil and China account for 80 percent of the trade deficit, and without more substantial progress on energy policy and the Chinese currency, the trade deficit will remain in the range of 5 percent of GDP. Again for ideological reasons Bernanke and Henry Paulson refuse to meaningfully address the Chinese yuan problem, and evolving changes in U.S. energy policy are too timid to have much consequence.

Over the next several months, the Federal Reserve will face increasing pressure to further lower interest rates but thanks to poor federal policies, Ben Bernanke will have to accept higher inflation to avert or limit the depth of a recession.