Fed Must Walk the Line…

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Commentary: Fed will have to tread carefully between too much tightness and not enough

By Irwin Kellner, MarketWatch

PORT WASHINGTON, N.Y. (MarketWatch) — Now that the economy is growing again, the Federal Reserve is on the horns of a dilemma: tighten money too soon and the economy could swoon into a double-dip recession. Wait too long and the humongous amount of liquidity the Fed has injected into the financial system will fuel a new round of inflation.

Kellner’s Forecasts
date report forecast previous
Oct. 19 Home builders’ index 20 19
Oct. 20 Producer price index -0.2% 1.7%
Oct. 20 Core PPI 0.2% 0.2%
Oct. 20 Housing starts 605,000 598,000
Oct. 22 Jobless claims 500,000 510,000
Oct. 22 Leading indicators 0.6% 0.6%
Oct. 23 Existing home sales 5.25 million 5.10 million

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To avoid either outcome, Fed head Ben Bernanke will have to walk the line between too much tightness and not enough.

Thus the hard part of the Fed’s job is about to begin.

It was easy flooding the economy with money to stave off deflation. After all, just about everyone likes cheap money and plenty of it.

The hard part will be when and how fast to withdraw this excess cash.

Economic growth, such as apparently occurred in the third quarter and is set to continue in the current period, is not enough. After all, millions of homeowners are still suffering, while the unemployment rate is nearly 60% higher than it was last year at this time and shows no signs of peaking.

To make matters worse, the number of long-term unemployed is the highest in recent memory, with jobs increasingly hard to get. As I noted two weeks ago, Manpower says that employers’ hiring plans for the current quarter are at their lowest point since this survey was started, back in 1962. ( See Oct. 6 column.)

If this was all the Fed had to concern itself with, it would be a slam-dunk for the central bank to keep its benchmark fed funds rate at its current record lows and leave its swollen balance sheet alone.

But there is another view that is slowly starting to take shape among investors. It’s called fear of inflation.

You can see it in the price of gold. The yellow metal is up by $258 an ounce, or 32%, over the past year, to just under its all-time high.

Another indicator that the Fed should be paying attention to is the difference in yield on the plain-vanilla Treasury note and that of the Treasury-Inflation-Protected-Security of comparable maturity. This is known as the Treasury-TIPS spread; the bigger the spread, the more investors fear inflation.

According to data made available by the Federal Reserve Bank of St. Louis, this spread is currently a tad under 2%. Last year at this time it was half this much and heading lower, reaching zero by year-end, when inflation fears were virtually nonexistent.

Then there is the price of oil. Light sweet crude oil closed Monday at $79.51 per barrel. This is above its year-ago levels — and 2-1/2 times higher than the price at which it started this year.

The weak dollar is fueling these inflation fears. As I observed last week, the dollar’s value is determined by supply and demand — and right now the financial markets are swimming in dollars. ( See Oct. 13 column.)

It’s hard to imagine the Fed pulling money out of the economy with housing in the dumpster and unemployment yet to peak.

But the drop in the dollar and concomitant rise in gold, oil and other commodities argues for some withdrawal.

And you thought it was tough for Johnny Cash to walk the line.