Consumer Price Index Drops

To begin, before the Fed offered its surprise news today, there was some important news on inflation this morning.  A big drop in the Consumer Price Index reported this morning, followed by the Federal Reserve Board’s announcement of a drop in the federal funds rate to a target between zero and .25 percent, punctuated the fight against falling prices that has been triggered by the global credit crisis.

According to the Bureau of Labor Statistics (BLS), the Consumer Price Index for All Urban Consumers (CPI) declined by a seasonally-adjusted 1.7 percent in November 2008 – year-over-year, however, the CPI increased by 1.1 percent.  The decline in prices was due entirely to a drop in energy prices, most notably gasoline.  The BLS noted that the gasoline index fell 29.5 percent in November and gas prices are now 47 percent below their July peak.  Food prices rose 0.2 percent in November.  The “core” CPI (that is, excluding food and energy prices) was flat in November, and is up 2 percent since November 2007.  So, despite the ups and downs of food and energy prices, inflation is running at about 2 percent.  This is a welcome respite from the 5.6 percent inflation rate seen at the end of July.

The drop in the inflation rate is disinflation.  Too many media outlets are jumping to the conclusion that the U.S. economy is experiencing deflation.  Thus far, the only areas where prices are falling are energy, transportation, and, to a lesser extent percentage-wise, housing.  Deflation is a threat, and it should be the government’s focus for now.  With the real money supply shrinking as banks continue to hoard cash and make borrowing difficult and expensive, we are headed toward a deflationary economic environment.  But this can be forestalled and possibly prevented by proper government intervention.

Fed Goes to Zero

Today, the Federal Reserve fired off the remainder of its interest rate arsenal in its campaign to defeat the recession by dropping its federal funds rate to a range between zero and .25 percent from 1 percent.  This is historic, not only because the target rate has never been this low, but also because the Fed has never used a range as its target.  The federal funds rate is the target rate at which banks may make short terms loans to each other.  Generally, once it sets the target, the Fed then manipulates the money supply until the market reaches the target rate. However, in the instant case, the effect of the Fed’s move will be limited (to the extent there is any at all), however, because the actual federal funds rate has been running at approximately .50 percent for the past month or so.  Last week, the rate on federal funds was .13 percent.  So, by lowering the rate, the Fed is merely acknowledging market conditions, rather than setting a new pace that will spur borrowing.  Especially now that the Fed rate is near zero, the Fed must consider and implement alternative policy tools to prop up the weak financial industry.  The goal for now is simply to avoid catastrophe.

In a rare media conference following the rate announcement, the Fed also noted that it would use its balance sheet as another weapon in the war on the recession.  What this refers to is an expansion of the Fed’s balance sheet through various types of lending, including the continuation of programs already begun, such as the Term Auction Facility, which has helped to bolster the commercial paper market by giving businesses access to short-term borrowing from the government.  The Fed further hinted that new lending programs will be forthcoming, and it will most likely purchase assets, such as mortgage-backed securities.

While all of these actions will help to put support under a sagging economy, the net effect also puts tremendous pressure on the value of the dollar.

Housing Starts Fall to New Lows

The other economic news of the day, which has been buried by the Fed’s announcement, was the startling drop in housing starts.  Granted, nothing negative in housing should be particularly surprising, but the speed of the decline in the construction industry does merit some attention. New construction starts dove 18.9 percent in November, which is the sharpest monthly percentage drop since March 1984, when housing starts dropped 26 percent.  The seasonally adjusted annual rate for housing starts of 625,000 marks the lowest rate since the Commerce Department began tracking records in 1959.  Starts for single-family homes also fell to a new low of a seasonally-adjusted annual rate estimate of 441,000, a 16.9 percent drop, in November.  Over the past year, housing starts have fallen 47 percent as an excessive inventory of homes dragged the builder sentiment index to an all-time low in December.