The Case for a Dovish Fed

October 12, 2009

The Federal Reserve has gone on the offensive to sell its exit strategy to investors and the public, in the hopes that it can stall an increase in inflation expectations. The effort was first launched by Fed Board Governor Kevin Warsh, who argued in a Wall Street Journal editorial, followed by a speech, that when the time came for Fed tightening, policymakers might have to move quickly. Even Bernanke, whose Great Depression expertise usually pegs him as a dove, was particularly meticulous about describing the Fed’s stimulus-withdrawal tools this week, sending the bond market into a tailspin.

But with the unemployment rate rapidly climbing toward 10 percent — and expected to remain up there for the foreseeable future, some economists are telling Fed officials to hold their horses. Paul Krugman, in his blog, makes a vehement case for an ultra-dovish policy stance. He calculates that the ideal fed funds rate given current economic conditions should be, get this, -5.6 percent. In another post, he argues that even if the U.S. economic recovery is more robust than most believe, the Fed should still keep rates at rock-bottom lows for at least two years.

So where’s the case for monetary tightening? For some reason many Fed officials seem to view it as inherently unsound to stay at a zero rate for several years running — but I’m at a loss to understand what model, or even conceptual framework, leads them to that conclusion. One gets the impression of officials who have decided that they want to tighten, and are making up new conceptual frameworks on the fly to justify their desires.

Enter Thomas Pulley, economist at New America Foundation, who argues in the FT that a second Great Depression is still possible. He argues that continued deleveraging and an adverse feedback loop of rising joblessness and foreclosures will likely lead to a renewed contraction in economic activity.

There is a simple logic to why the economy will experience a second dip. That logic rests on the economics of deleveraging which inevitably produces a two-step correction. The first step has been worked through, and it triggered a financial crisis that caused the worst recession since the Great Depression. The second step has only just begun.


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The dovish case for easy money seems to rest on the “there-will-be-no-inflation-with-a-large -output-gap” argument. But this argument misses the possibility/likelihood of inflation based upon a debasement of the Dollar as investors/speculators/individuals dump their fiat currency to purchase hard assets. As more Dollars are printed – each Dollar has inherently less value. Investors are becoming more aware that the Fed/Treasury policy is to allow the Dollar to decline. As it becomes a carry-trade funding currency, the decline accelerates. As the Dollar gets sold – it gets sold for oil, gold, copper, and other tangible assets (especially ones that can be used by Asian currencies).

So, oil goes up, copper goes up, and all of our ‘inputs’ go up. But because we import a lot of these products, our wealth as a country actually declines. Consumers pay higher prices for goods, but we haven’t benefited proportionally from the rise in prices. Therefore, overall demand goes down, jobs are lost, etc. Um, it’s called STAGFLATION. We’ve seen this movie before. Consumers and investors want to get rid of their Dollars as quickly as possible, but not because there is too much demand per se, but because they have no confidence in their paper currency.

The difference from the 1970’s and now is that the baby boomers are retiring and the Medicare/Medicaid/SS structural deficits are coming up. And we’ve spent trillions more since then, and shipped most of our manufacturing jobs overseas. We’re ill-prepared and ill-equipped to grow our way out of this. The boom of the 2000’s was nothing more than a debt-fueled binge.

We can’t solve a de-leveraging recession with more debt and more spending. It will be some pain now, or even more later. They’re currently trying to fix the economy’s problems with the standard Keynesian prescriptions and loose money with some good old-fashioned money printing thrown in (quantitative easing). As these continue to fail they will continue to do more (they’ve made it clear they will do ‘whatever it takes’).

My prediction: the Dollar will collapse as currency in the next 10 years – as it becomes ever more and more clear that we do not have the appetite to fix our problems. We will have to either default or hyper-inflate our way out.

Posted by Trader Joe | Report as abusive

What we have to face is that deficit reduction is only possible in our system with great leaps forward in productivity accompanied by gridlock in our political system. If our budget is ever going to be restored to sanity, it will be because we had another massive leap forward in innovation. A revolution in energy would be the most likely candidate.

Posted by syndicate | Report as abusive