The Fed's True Dilemma

ISSUE: The Fed’s True Dilemma – GDP today showed a severe drop in inventories.  And everyone knows about the inventory cycle; NEC head Larry Summers was just talking about it this past weekend. The severe inventory drop is one of the first events that has alerted a widespread audience (instead of a few technical observers) to the idea that although the cycle correction still is severe, the economy could be closing in on an end game for recession. Summers, himself, has vaguely spoken of this recession as going on for the unspecified period of ‘some time.’ So far there is little talk of the potential for a STRONG economic recovery yet this severe drop in inventories certainly raises that specter. Several Fed observers have said that history shows us that the challenge for a central bank is to NOT TAKE AWAY THE STIMULUS TOO SOON. 

Yet, in this cycle in the midst of the crisis the Fed was being assailed for not having an exit strategy. Recessions are about strong cyclical forces that play one way then shift to the other. Yet a number of structural issues have been at work in this recession that has had (1) an ongoing housing crisis, (2) a financial crisis, (3) booming and busting oil prices, (4) severe damage to consumers’ wealth via housing, jobs and the stock market decline. These strong structural issues are still in play and are not fully remedied. 

Yet, the economy appears poised for a sharp increase in growth once the recession part plays out as the inventory figures hint. There is a huge stimulus program that is just beginning to uncoil. Plus there is the usual cyclical rule: Severe recessions promote strong recoveries. The question is how the Fed will react to that if it happens? Will it be pressured by monetarists to pull back on the stimulus? Will the Fed pull it back too soon? If it does react to the cyclical forces what of the still remaining structural imbalances? When the strong cyclical rebound that is an economic recovery plays out, will the economy be able to sustain expansion if the Fed begins to dismantle its help programs and raise rates? These issues make up the Fed’s true dilemma.