Business Insider

Peter Crabb: Consumers, government face tough tradeoffs now

We all face tradeoffs.

If we want to spend more time doing one thing, we have to give up time that may be well spent elsewhere. If we want to buy more of something, we have to give up spending that money on something else.

Government policymakers don’t want to face the tradeoffs in front of them.

A classic monetary policy tradeoff continues to face the Fed – low interest rates are sparking inflation. Even with the financial panic of 2008 well behind us, the Fed must continue pursuing its stated mission of high employment and low inflation. Unfortunately, these two goals are often in conflict.

The Fed has pushed interest rates to zero and thinks they will have to stay there. At the August meeting of the Federal Open Market Committee, policymakers said weak economic conditions are likely to continue for some time. In response the committee promised to keep interest rates near zero through the middle of 2013.

Keeping interest rates low to support employment causes inflation to rise. The U.S. Consumer Price Index is up 2.6 percent over the last twelve months. The situation is only slightly better here in Idaho and other western states. The CPI for western cities the size of Boise is up 3.5 percent over the past twelve months.

The most recent action by the Fed suggests it is less concerned with the inflation goal and more concerned with employment. There are nearly 14 million unemployed workers in the US today and many others working in part-time positions because full-time work is unavailable.

With interest rates near zero, monetary policymakers have done all they can to encourage consumer spending. The Fed has given everyone a strong incentive to borrow but few are taking the bait.

With monetary policy losing its effectiveness eyes are turning to the federal government, or fiscal policy, for help. Unfortunately, policymakers face a tough tradeoff here as well.

If the federal government chooses to enact some another economic stimulus plan, like new highway projects or reduced payroll taxes, it lowers the long-term economic outlook because of increased government deficits and higher debt levels.

Consumers also face big tradeoffs.

Households can consider borrowing for a new house or a new car but must consider this decision against the backdrop of a weak labor market. Anyone at risk of joining the millions of workers on the unemployment roll does not want to take on new debt.

Even when a consumer does decide to borrow he or she faces the tradeoff of a higher down payment for better terms. Putting more money down gives the lender an incentive to make the loan at a favorable interest rate, but the borrower is out more cash at a risky time for the economy.

Facing these tradeoffs, most consumers have decided to put off new purchases. The U.S. household savings rate jumped from 2 percent to 5 percent over the past four years.

Consumers and policymakers alike face tough tradeoffs in the current economic environment. Monetary policymakers are accepting higher inflation but have done all they can for employment. Consumers have decided to save more.

What will the federal government choose?