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Column: The Fed’s year of living dangerously
June 2, 2008
The remarkable ability of the Federal Reserve to coast above the turbulence of US politics has been tested lately. The central bank has been forced to deal with a financial crisis at least partly of its own making. It has rightly come in for some criticism; it has had to explain itself. Even so, the Fed and its policies are hardly front and centre in the debate between the presidential candidates.
Most voters say that they regard the economy and its troubles as the single most important issue facing the country. They want to hear what Senator Barack Obama and Senator John McCain propose to do about it but the Fed – where the real economic power resides – is mostly allowed to get on with the job unmolested.
I wonder if this will continue to be true. When a central bank has an uncomplicated recession to deal with, it can cut interest rates. When it faces a clear-cut case of inflation, it can raise them. The worst nightmare of any central banker – especially one with a tradition of political independence to defend – is stagflation, when raising interest rates to curb inflation will provoke a recession or deepen one that has already begun. It is a problem that the US has not had to confront for 30 years. In 2008, an election year, the conditions are falling into place.
The remainder of this column can be read here. Please post your comments below.
I have head anecdotal evidence that some people are even considering a decrease in their trips to Vegas for hi-stakes gambling and $200 lunches as a result of the economic sag. In one case in Cleveland a man was nearly forced to give up cable tv, only to be rescued by the economic stimulus check. Another man in Wisconsin was only able to take his powerboat on the water for 80% of the time he did last year, due to high diesel prices.
The US has certainly turned on its ear when 5% unemployment and 3.6% inflation, along with 7 uninterrupted years of economic growth is considered a recession despite all signs to the contrary. No matter how many times the media demands that the economy flop, the basic low tax/low tariff common sense of the federal government rescues us from the political hijinx.
JBP
Posted by: John Powers | June 3rd, 2008 at 10:05 pm | Report this commentDear Clive, Your presentation gives a persuasive argument that stagflation is at least a significant possibility for the US for the coming 12 months.
As you say, and everyone would agree with you, stagflation defeats our ordinary monetary control. To cure the “stag” you have to move in one direction and to cure the “flation” you have to move in the opposite direction.
However, a few tweaks to our “ordinary monetary control” gives a much improved control, that, when explained to all concerned – that’s everyone – will cure even stagflation.
The control has a very fast response. It has very frequent monitoring – every day - made possible by working on changes more than on absolute quantities. When it wants a stimulus it gives new money, to people who will spend it within a short time. And it uses the level of stocks of goods and services for sale (that’s a generalised inventory) as an intermediate parameter. For less stimulus it gives less money. However, for a required sharp change as now, it could put up the interest rate more than usual, but only for a very short time. In practice, however, with very full explanations, people will realise that the best way forward is to cut prices by a fraction of a percent and sharply increase inventory, as that would avoid the change in interest rates. The control would then increase stimulus by giving more new money for immediate spending and most of the pain of stagflation is avoided.
Some more information is in the first response to Willem Buiter’s first blog of May 28, 2008, “Lessons from the North Atlantic Financial Crisis”.
Posted by: Brian Stratford | June 3rd, 2008 at 10:49 pm | Report this commentFederal Reserve acts to resolve the crisis using the methods, which proved to be useless during recent years. The state of panics is growing among American people. The question is: “What is next?”
Posted by: Viktor O. Ledenyov | June 4th, 2008 at 2:28 pm | Report this commentthe risk of stagflation is a function of the diminishing returns on the greenspan era monetary policies. The natural course of capitalism is to invite innovation, to see old business models fail and a new and stronger version of the macro economy rise.this process of survival of the fittest and smartes and most creative and….was interupted repeatedly by the greenspan fed. the natural evolution of death and rebirth was deemed too painful a course following the volker years. a review of interest rates since 1985 shows how the fed manipulated rates in attempts to forestall corrective recessions or at least to lessen the “damage” of the economic cycle.with the simple interpretation we know that the fed engineers higher short rates to slow economies and cuts rates to stimulate faltering growth. Since 1985 these interest rate cycles have resembled a golfball bouncing down a flight of stairs. lower highs and lower lows in rates have been required to achieve the feds goals regarding the pace of expansion. in other words it has taken less to slow the economy and more to stimulate it. the diminishing returns of the feds misguided policy are the source of its current dilema. it is difficult to cure an illness through more of its cause.misguided resues and bailouts have left the us economy to grapple with companies that require life support in the form of inflation adjusted free money- and more of it through each business cycle or stupendous blunder.the falling dollar is the world’s way of enforcing market discipline on the us. the next step, perhaps a far more damaging one would be the loss of foriegn capital to fund our deficits. the subprime mess has educated the most vibrant members of the global economy regarding the moral hazard associated with the ways of the greenspan fed. poor ben is left holding the bag.will he do more of the same? does he have viable alternatives to free money bailouts for the financial and housing sectors? ben has been a proponent of inflating our way out of deficits through money supply manipulation. with diminishing returns his policy may produce less bang for the buck and the economy.
Posted by: gym-bob | June 4th, 2008 at 4:29 pm | Report this commentThe liquidity provided by the Greenspan post-dot com stimulus, in conjunction with the preposterous bonus structures within the finance world, created the current systemic financial crisis. The whole chain of the financial system gorged on the cash provided by central banks using high risk, high leverage “innovative” instruments. The bonus system made the high risk behavior inevitable. How many people would not be tempted when you can use other peoples money to put a million dollar bonus in your pocket? As reported by cnnmoney.com, the 2007 bonus pool was $33.2B only slightly less then the record $33.9B for 2006. Yet this was given out in 1Q2008 just before the fed bailed out the system from collapse. Will this behavior change based on these events? The smartest people on the planet are attracted towards the finance world due to its incentive system. There will always be another crisis building when these people have such large carrots dangled in front of them. How can the fed control this?
Posted by: Ismail Sola | June 8th, 2008 at 5:46 am | Report this commentIsmail nails it regarding the street and its megalomaniac business model.Greed is a powerful force that alters reason and character.Wall Street attracts sharp minds with clouded vision- clouded by greed and a system of rewards and punishments tied to fee and commisiion generation.Armed with trusty bell curves engineers can concoct models that assure success and diminish the perception of risk all the while encouraging levering up a sure thing. Fat tails blow these models apart with all too common regularity and leverage magnifies the damage. Has anyone heard a wall street banker take resonsibility for the current mess? There is a sure fire way to reduce the damages caused by brokers and bankers- restrict leverage to some reasonable multiple of capital. Left to their own devices the greedy will lever up to the max and push the limits of financial modeling to “hit their numbers” and collect their bonuses. We saw 17:1 rip the Bear hedge funds apart. We know of 20:1 and even 30:1 at today’s finanancial behemoths.Do any ofr the financial companies actually own anything? We can’t change human nature or its worst traits. We can put regulatory controls on leverage for both on and off balance sheet adventures. Structured finance is on the ropes because it failed in its current form.Fianancial models need obvious repair and smart people to question and perhaps regulate the assumptions that set the table for disaster. And returning to the fed- it is far from apolitical and to suggest otherwise is to advance a canard. Now the fed of big ben has entered territory not visited since the 1930’s, providing liquidity to brokers to keep money markets from seizing and counterparties from failing. Putting the feds balance sheet at risk puts the dollar and taxpayers necks on the block if things get further out of control.Limiting leverage may lessen the impact of the fed’s undisciplined profligacy when its friends suffer from self inflicted wounds.We will likely not return to debt ratios being determined as a percentage of capital rather than a multiple of it but some movement in that direction could help soften the next blow. And of course there will be a next blow. Ismail points to the flaming heart of capitalism- greed. The beast that is the street has little fear of real failure, the kind that carries life altering consequences. The fed needs to get out of the way, take away the safety net that distorts competitive capitalism. In a financed based global economy we need banks and brokers and ratings companies and even some structured finance. We can’t nor do we wish to extinguish risk taking. But the “heads i win tails you lose” mechanics of todays capital markets will destroy what makes capitalism work. What we dont need is narcisistic avarice supported by moral hazard and taxpayer wallets.
Posted by: gym-bob | June 8th, 2008 at 9:53 pm | Report this comment