Stimulus package begins to work

June 27, 2008

After a bad day yesterday on the Wall street markets during which the DOW dropped 350 points and came very close to breaking through the bearish barrier today on the markets should end better than yesterday. This is because the first real evidence that the stimulus package is beginning to do its work became clear as last month's results for consumer income and spending   were released. They showed a rise in consumer income before inflation that was well above the previous month and which exceeded expectations. Immediately the futures markets reacted moving sharply upward. This is just the first round impact of the stimulus as only a portion of the   rebate cheques were mailed out in April and May. More spending is to follow as well as second round positive impact from the first round of spending. The American economy is not out of the woods yet but it is time for some of the excessive pessimism to be dissipated. Uncertainty and irrational expectations still rule the financial markets, unfortunately.
The complicating factor is the sharp rise in oil prices yesterday touching 140 dollars a barrel.(today oil is trading at close to 142 a barrel) Because of this the headline inflation rate is sending the wrong signals to both investors and the Fed who in their recent interest rate announcement hedged their inflationary bet by holding interest rates at their present level. In real terms the Fed interest rates are reasonably low (but market rates still too high) To be on the safe side the Fed could have cut them an additional 25 basis points and kept its tilt toward easing.

As I explained in an earlier post on the Bank of Canada's unwillingness to cut rates, Charles Schultze established as early as 1959 in a study for the joint economic committee of Congress on the problem of inflation that the best way to understand the inflationary process is by using a disaggregated approach .
As I have argued in my own research one has to identify the sectors of the economy in terms of their oligopolistic or competitive character, the degree of trade union presence, their break-even point, and their degree of capacity utilization in order to assess their contribution or lack there of to the overall rate of inflation.
It makes little sense in an otherwise non inflationary environment to attack price rises in a cartel controlled industry like the oil sector through central bank interest rate rises. The result is likely to be stagflation, not a pretty outcome.In the months ahead so long as the Fed doesn't lose its nerve and jack up the rates prematurely I expect the stimulus package supported by an accomodating monetary policy to continue to do its work to help restore prosperity to the American economy.

By the late fall we should know if more stimulus is necessary or if a full recovery is underway.