September 26, 2007
Fed must weigh inflation against recession
By Martin Wolf
"I regret to say that the Federal Reserve independence is not set in stone. FOMC discretion is granted by statute and can be withdrawn by statute." Alan Greenspan, The Age of Turbulence.
To critics it is now the "Bernanke put" - the belief that, as under Alan Greenspan, the US Federal Reserve will always ride to the rescue of Wall Street. The jubilant response of traders to the Fed’s 50 basis point cut in the short-term interest rate might justify this suspicion. But saving Wall Street from its follies is not the Fed’s objective. It is an (unfortunate) by-product of the attempt to do its job.
It would be wonderful if those responsible for this most absurd of financial crises could be punished without damaging millions of innocent bystanders. But it is impossible. If the Fed does its job, it helps the financial sector. The latter will, no doubt, recover and then find some new, imaginative and currently unforeseen way to generate a possibly bigger crisis several years hence. Whereupon, it will expect the Fed to do its job, as Wall Street sees it: saving the economy, by saving finance. Moral hazard matters, but only for the poor.
Yet will the Fed always be able to oblige? The answer is not so clear. The resolution of each crisis lays the seeds of the next. Thus, the easing by the Fed after the east Asian and Russian crises of 1997 and 1998 contributed to the subsequent stock market bubble. The dramatic easing after its bursting in 2000 contributed to the recent housing boom. The disruption in money markets brought about by the end of that boom has led to last week’s sharp cut in rates. The question, then, is what this will lead to.
The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.
Ronald McKinnon: Martin Wolf’s analysis of the Fed’s fine balancing act in reducing interest rates to offset the US housing slump, but without re-kindling inflation, is nicely done. He correctly identifies the decisive swing variable to be the dollar’s nominal value in the foreign exchanges. Keeping the dollar up is the most efficient way of maintaining confidence that the inflation threat can be contained.
Wolf notes that when Fed Chairman Ben Bernanke says that a strong dollar is good for the US economy, this “is an aspiration without a policy, and, as such, is misleading, if not meaningless”. But can the Fed, and the US government more generally, make a strong dollar to be a positive objective of policy? Currently, the US Congress is writing legislation to sanction China, and possibly other countries with trade surpluses, with tariffs or anti-dumping duties unless they appreciate their currencies, i.e., devalue the dollar, substantially. And China could be the linchpin: if the renminbi appreciates substantially, so would other countries in Asia and elsewhere. The inflation problem within the United States would then be greatly aggravated.
Posted by: Ronald McKinnon | September 27th, 2007 at 6:31 pm | Report this commentSo Chairman Bernanke should warn the relevant congressmen in both the Senate and House that his job of ameliorating the housing induced downturn in the American economy without rekindling inflation would become impossibly difficult if this protectionist legislation was passed.
Martin Wolf: Like Ronald McKinnon, I am strongly opposed to protection. But I cannot see any plausible way of preventing the depreciation of the dollar. Who is going to be willing to hold a currency that offers such large risks and modest returns and whose excess of spending over gross domestic product is so large? The answer has been, to a considerable extent, foreign governments. But can their willingness to buy US liabilities, denominated in dollars, really be without limit? As Ron knows, I prefer a depreciation of the dollar all round, rather than the partial appreciation we are seeing today, which seems to me to be seriously distorting for world trade and very dangerous for preservation of an open trading system.
Posted by: Martin Wolf | October 25th, 2007 at 1:03 pm | Report this comment