Why The Fed Should Embrace Inflation

Tim Duy has another astute FedWatch today, chez Thoma, in which he reiterates that although it's a close-run thing, he reckons the Fed will stand pat at its next meeting, essentially riding on the bigger-than-expected rate cut in September. On the other hand, he says, he may be underestimating the degree to which the Fed is worried about the housing slowdown:

My concerns about inflation are irrelevant, as are Ritholtz’s. Bernanke & Co. are currently more focused on the downside risks to growth. The primary risk to growth stems from the housing market. If you focus on the housing story, then, you conclude that the Fed will cut rates at months end. If you focus on the “potential impact of housing to the broader economy” story, then the Fed was intentionally getting ahead of the curve with the 50bp cut in September, allowing them to take a pass on October unless they saw broad based weakness.
I have shifted increasingly to the latter camp. If I make an error on that call, it will be because I have focused on the externally driven growth as a real, structural shift in the US economy. In fact, the Fed may discount the external growth story, choosing instead to cut again on the basis of the housing slowdown.

The tug-of-war here is clear. On the one hand, weakness in the housing sector means lower economic activity. "By all rights, or at least to the extent that we believe history should repeat itself, the housing downturn should already have tipped the economy into recession," says Duy. By these lights, the Fed should cut rates in order to counteract the deleterious effects of the housing slump. On the other hand, a rate cut could mean higher inflation, which is a bad thing.

I see things slightly differently: in many ways, now is exactly the point at which the US economy could do with a little bit of inflation, just so long as it didn't affect long-term inflation expectations too badly. If I could call down inflation now, in the understanding that it would have no effect on inflation in a few years' time, I would do it. Because inflation is just the ticket for homeowners who are struggling with negative equity.

The big problem in the housing sector is that houses are worth less than the mortgages on them. The mortgages are denominated in nominal dollars, and inflation, even if it has no effect on real (inflation-adjusted) house prices, will certainly have an effect on nominal house prices, and bring a significant number of homeowners back into the promised land of positive equity.

In other words, while Hank Paulson is struggling with the housing crisis, a lot of the solution to it could be in the hands of Ben Bernanke. I like the idea of another rate cut at the upcoming Fed meeting, keeping the central bank ahead of the curve. The Fed can be dovish now, turning much more hawkish in the future, when there isn't a debt crisis going on at the individual-household level.