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The Good, the Bad, and the Ugly

12:00 AM, Jan 22, 2011 • By IRWIN M. STELZER
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Whether Armstrong and others worried about inflation will be proved wrong will depend on whether the Fed can figure out when and how to sell its huge holdings of bonds, and pull the proceeds out of circulation; and whether the Democratic president and the congressional Democrats can work out a deal with Republicans to cut the deficit.

Neither is certain. The Fed has just released minutes indicating that it saw the housing bubble inflating in 2002, but didn’t want to or know how to pop it. And on September 16, 2008, the day after Lehman Brothers went down, the Fed’s Open Market Committee believed the risks of slower growth and of inflation were about equally balanced. The minutes read, “Although the downside risks to growth remained, the upside risks to inflation were also of significant concern to the Committee.” The Fed might be better at predicting and policy-making than it was just a few years ago, but that is far from certain. We will know more after the Fed’s monetary policy meeting in March, which is when discussions of how to bring its bond purchases to a halt in June, as now scheduled, will begin. Meanwhile, the administration is committed to continued spending to accelerate job creation in advance of the 2012 presidential and congressional elections, and the Republicans, with a large Tea Party contingent now in the House, are committed to opposing any tax increases. If both parties refuse to compromise, the deficit will continue to mount, the Fed will have to buy the newly issued IOUs, inflation will take off, the Chinese and others will decide not to buy and possibly to sell dollar assets, the Fed will have to raise interest rates to stem further declines in the dollar. That will slow growth, making it more difficult to repay the debt.

We should enjoy the good, can’t do much about the bad, but certainly can avoid the ugly with a bit of common sense and compromise, perhaps along the lines suggested by the president’s deficit commission, or by Congressman Paul Ryan. We will be better able to judge whether these virtues are available when the president delivers his State of the Union message on Tuesday. We’ll then see whether he is prepared to compromise on his high-tax, anti-business, pro-regulation program in response to the “shellacking” he says he took in the recent congressional elections. And we will know still more when we see whether the Republicans can use the debates over the increase in the debt ceiling to begin to nibble away at the government’s out-sized spending.

Do not abandon hope all ye who are watching these developments. As Goldman Sachs’ Investment Strategy Group put it -- and this bit of cheer was prepared in offices that must have been suffused with gloom over the meager bonus pool -- “We remain optimistic about the US on a longer term structural basis…. We believe the strength of government and private sector institutions, the resilience of the economy, the rule of law and the respect for property rights will carry the day for the foreseeable future.”  

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