The Fed Pause That Refreshes? Hardly.

By Steven Pearlstein
Wednesday, August 9, 2006

Pay no attention to all the hullabaloo about the Fed pause. In the scheme of things, it won't matter much. The cake, as they say, is already baked. Over the next two or three years, the U.S. economy is in for a period of uncomfortably slow growth and uncomfortably high inflation, and there's little the Fed can do to prevent it.

This is not the story the Fed or the financial markets want to hear. They've convinced themselves that by slowly and steadily raising short-term interest rates over the past two years, the Fed can engineer a "soft landing" for the economy, one in which a brief period of slow growth will contain inflationary pressures. And they expect that by the middle of next year, the U.S. economy will be back in the comfort zone of moderate, non-inflationary growth.

So what's wrong with the soft-landing scenario? Plenty.

It is premised on an outmoded view that inflation happens when the demand for goods and services exceeds the ability of a national economy to supply them. We have now experienced a prolonged period of economic stagnation with high inflation (the late 1970s) and a prolonged period of robust growth with low inflation (the late 1990s). What those "anomalies" suggest is that inflation may have other causes, and that it may not always be possible to control it by using interest rates to manipulate demand.

One overlooked factor has been asset prices. Starting with the oil-price shocks of the 1970s, and continuing with the takeover craze of the 1980s and the technology bubble of the late 1990s, these investment flows have had a profound impact on the behavior of consumers and businesses, and the ups and downs of the business cycle.

Right now, the air is gushing out of a real estate bubble that, by some accounts, has been responsible for 30 percent of the job growth over the last few years and several percentage points of the annual growth rate. Now the government reports that, during the second quarter, investment in residential real estate fell by 6.3 percent, which means that rather than being a source of growth, real estate is a drag on the economy. And the drag is likely to increase as new home construction slows and declining values discourage homeowners from taking equity out to pay for vacations, new TV screens and kitchen renovations.

And while we're on the subject of bubbles, let's not forget the surge of money flowing into buyout funds, hedge funds and venture capital funds, driving up the prices of companies, commodity futures and other derivative contracts to ridiculous levels. It should tell you everything that the winning strategy in private equity these days goes by the name of "strip and flip" -- buy a company, load it up with enough debt to pay yourself a big dividend, then sell it to another private equity firm hoping to do the same thing all over again.

One reason for both the real estate and private-equity bubbles is that there is too much cheap money sloshing around the global financial system. This excess liquidity began to develop in 1998, when the Fed and other central banks pumped money in response to the Asian financial crisis. They did it again in 2001, after the bursting of the stock-market bubble, and again in 2003, as a defense against Japanese-style deflation.

During the last two years, the Fed has tried to sop up some of that excess liquidity by raising the short-term interest rates under its control. But to a surprising degree, those efforts have been thwarted by China's central bank, as it has sought to keep the yuan pegged to the value of the dollar. By printing up yuan to buy all those extra dollars earned by Chinese exporters -- and then investing those dollars in U.S. Treasury bonds -- the People's Bank of China has effectively been adding to the global money supply and pushing down interest rates, even as the Fed has been struggling to do just the opposite.

All this is rather complicated. But in simple terms, it means that, along with shoes and toys and auto parts, an overheated Chinese economy is now exporting inflation to the United States. This is reducing the Fed's ability to manage the U.S. economy.

For years, economists have warned that the United States cannot continue to live beyond its means by running large and persistent trade deficits. At some point, the piper must be paid. And that point is upon us. We will either pay the price through slower growth or higher inflation, or, as now seems likely, through a combination of the two.

Ultimately, both will have the same effect, lowering our standard of living until the global economy comes back into rough balance. Pause or no pause, the Fed's task is not to forestall that needed adjustment, but to see that it happens in as orderly a fashion as possible.

Steven Pearlstein will host a Web discussion at 11 a.m. at He can be reached

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