When the subprime crisis first broke in August of last year, few anticipated the extent and depth of the crisis. At that time it was estimated that subprime related losses would be about $140 billion. The situation was bad but not impossible and Bernanke rightly assumed that simple adjustments to interest rates would take care of the situation. But the banks and financial institutions had hidden their risky investments too well in off balance sheet entities, to avoid regulatory supervision, as a result of which losses were grossly underestimated. As the magnitude of the crisis unfolded, there was panic all round and the Fed's primary task became one of saving the financial system, never mind inflation or the value of the dollar.
In order to prop up the financial system an unprecedented amount of money has been pumped into the market. It is this growth in money supply which lies at the root of inflation, although it has become fashionable to blame emerging market growth and commodity prices for it. Inflationary pressures coupled with falling home prices, have finally taken their toll on consumer sentiment. A near stagnant economy, together with falling asset prices and the devaluation of the dollar has impoverished the American people.
The economic numbers released lately paint a picture of the economy which is not as grim as expected, which has prompted many experts to stick their necks out and predict that the worst is over. But this may not be the case, and in fact the worst may just be about to begin. This is because in order to fight inflation the Fed will have to increase interest rates sharply, although it may choose to wait till after the November elections to do so. Central banks all over the world are expected to follow the Fed in raising interest rates to tame runaway prices. The impact of rising interest rates on an economy already teetering on the brink of recession is almost a foregone conclusion. Economic activity in the US is expected to decline further. These recessionary conditions will put further pressure on asset prices and they are expected to fall across the board. Bond prices will fall as interest rates rise, as will stocks, as higher interest rates eat into corporate profitability and falling demand reduces their ability to raise prices. Home prices are already projected to continue falling till the end of the year at the very least.
Banks and other financial institutions have already written down the value of their assets by about $389 billion, which has impacted their share prices. Reduced economic activity will impact future revenues and reduce earnings as well as valuations. The only chance of avoiding this scenario would be if by some miracle oil and commodity prices were to come down sharply. If this happens without having to raise interest rates too far, a deflationary spiral may perhaps be avoided.