The economy is now officially in a recession, and will continue to produce dismal statistics for some time.  In my opinion, we were done in by the combination of oil prices that went way too high last spring and summer and by some absolutely irresponsible risk taking on Wall Street. That said, there are some lights at the end of this dark tunnel.

On Tuesday, the Federal Reserve (Fed) released a highly unusual monetary policy report. First, they announced that the fed funds interest rate target would be cut to a range of 0 to 0.25 percent.  Both the fact that the Fed set such a low level and the fact that they indicated a range rather than an exact target are unprecedented.  And the Fed made it clear that this interest rate would stay low “for some time”—in my opinion an extraordinary commitment.  Second, they said that inflationary price pressures have diminished—an understatement, in my opinion, when the CPI has been falling sharply lately and is soon headed for zero or negative 12-month rates of change.  Third, the Fed said they “will employ all available tools” to fight this recession.  And, again in my opinion, they have been.  The Fed is fully engaged in dealing with the collapse of the financial system and the ensuing recession using a wide array of programs and a huge expansion of money.

Along these lines, the Fed announced that they will purchase additional agency and mortgage-backed securities to support the housing market, a program that is already underway and has reduced mortgage interest rates.  The Fed also stated that they may begin purchasing longer-term Treasury debt, and they also announced a new program to “facilitate the extension of credit to households and small businesses”.  All of these actions will help restore order to credit markets and will increase the money supply.

Certainly there are risks to this strategy.  While we may well experience deflation over the near term, we may experience a sizable rise in prices in 2010.  I do think the Fed has decided that a policy of reflation is necessary to counter the recession and to stop the decline in home prices. 
At the same time, the Treasury has gone quiet after the latest bailout, of Citigroup.  As I have said before, this new program has great potential for lifting risk off of bank balance sheets and providing lending capacity at sensible terms and rates. These programs need to be expanded. I think that current market instability is related to the Treasury’s recent inaction, and I expect a renewed effort from them soon.

On the bright side, I see the very sharp decline in energy and commodity prices as beneficial to U.S. business and consumers.  My estimate is that the decline in energy prices will cut the annual consumer bill by about $290 billion.  In the short term the price declines hurt equity prices in associated industries, but longer term they are beneficial to the economy and financial markets.
OPEC is reducing production in an effort to drive up crude prices, but without a robust economic engine, I don’t believe prices will return to levels anywhere near what we saw earlier this year. Even with 40% of the world’s oil production, OPEC does not have as much control as they would like to believe.

I do think that the President, President-elect, Congress and Federal Reserve are fully committed to solving this financial crisis. 

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