Time for a Fed fire drill

September 25, 2009

Former Federal Reserve Chairman William McChesney Martin joked that it was his job to “take away the punch bowl just as the party gets going.” But Alan Greenspan never did, choosing instead to spike it every time the party slowed down. The results were more than a little unfortunate.

Now, faced with years of economic stagnation, most economists conclude interest rates will stay low indefinitely. The Fed is doing little to disabuse them, though an opinion article from Fed Governor Kevin Warsh in today’s Wall Street Journal tries to warn us not to get complacent.

Warsh says, a bit technically: “‘Whatever it takes’… cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns.” In other words, if the Fed only intervenes during downturns, it risks its credibility as protector of the dollar.

But talk is cheap. Not since Paul Volcker raised rates significantly in the early 1980s has the Fed done anything substantial to fight the forces of irrational exuberance. The Fed won’t reestablish its bona fides until it puts the economy through pain.

With a “recovery” under way, the printing press running on high to support the housing market and $850 billion of excess reserves just waiting to spark inflation, the Fed’s credibility is, well, strained to say the least.

So Warsh goes a bit further: “Policy likely will need to begin normalization before it is obvious that is necessary, possibly with greater force than is customary …”

Dollar bears like me like the sound of “greater force than is customary,” but we don’t believe the Fed would actually use it.

Why should we? Earlier this week, the central bank put out another wishy-washy policy statement that says it will hold interest rates low “for an extended period,” while gradually weaning the economy from the support of the printing press.

That will only encourage investors to take on risks that will tie the Fed’s hands later on.

To avoid a return to that status quo, we need more than tough talk. We need a fire drill — a quick, small rate increase that no one is expecting.

Always telegraphing your moves months in advance is what breeds complacency. Investors make stupid mistakes and the Fed is left to pick up the pieces, putting the dollar at risk.

So, Kevin, if you’re worried about investor complacency, give us a rate increase when we least expect it. Perhaps next week?

6 comments

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When you think about it why are we having a debate about who’s side the Fed is on. Are people who saved there money being rewarded for their safe behaviour with interest rates at 0%. Or are the idiots at the Fed rewarding and reinforcing the risk taking behaviour that got the US in such a mess.
If you need to ask why the Fed takes this action, look at where 90% of ex Fed employees are working. Surprise surprise at the risk taking investment bamks.
If we truely want the Fed to be independent then employees should be locked out of working for financial companies for 20 years.
Remember Greenspan the guy that caused a lot of these problems. Where is he working now. Get the point. The average US taxpayer is being taken for a ride.

Posted by gd | Report as abusive

Rolfe,

I’ve long had a problem with the assumption that Volcker cured inflation with higher rates. Inflation is surplus money in the economy, but the higher rates the Fed imposed reduced the ability to borrow, which led to a recession. In a recession, less money is necessary, so while he drew down the supply, he also reduced demand.
Of course, inflation was brought under control, but the government was ramping up deficit spending at the same time, to the point that by 1982, it was about 200 billion.
What’s the difference between the Fed selling debt it is holding and the Treasury issuing fresh debt? The Fed retires the money it gets, while the Treasury spends it on public works, which do serve to increase investment in the private sector. So not only does it directly draw down the supply of money, in exactly the same way as the Fed does, but it also increases demand in the private sector.

Back in the day, inflation was blamed on unions(re: air traffic controllers) driving up wages and prices, but when the Fed (and Treasury) sells debt, it doesn’t draw money out of wages, but savings. Obviously it would seem that if there is a surplus of money, it manifests in those with a surplus of money and thus can afford to loan it out. The problem is those with the most, have the most influence and so it’s easier to blame those who don’t have nearly as much.

The problem seems to be that the law of supply and demand applies to capital, as well as capitalism. Since supply is potentially infinite, it is the demand for capital which ultimately defines how much wealth can be saved. That is why we have a credit crunch, as the financial industry manufactures endless unsustainable and/or artificial demand for what is ultimately illusionary wealth.

Now the government is blowing up the last and largest bubble to maintain our collective delusion, but eventually it is going to pop and even the bankers are going to lose big.

Posted by John Merryman | Report as abusive

Hey Rolfe,

Although no one will disagree that the FED, especially under Greenspan and Bernanke have been spiking the punch bowl, but most of their actions were within their legal authority.

The real problem was the FED’s failure to act instead of acting. Under HOEPA the FED was mandated to stop predatory lending practices.

Clearly, there is a huge difference between holding interest rates at historically low levels and allowing lenders, investment banks and credit rating agencies to conspire to securitize trillions in fraudulent loans as investment grade.

Providing 100% financing on stated income guidelines to wage earners whose income was easily documented on W-2s was nothing less than encouraging and blessing loan fraud. The rating agencies did nothing to verify the stated incomes even though IRS form 4506T was available in every single file.

Posted by Michael Blomquist | Report as abusive

I forgot to mention about opening the window to investment banks – would never have been necessary “but for” the rampant fraud in housing. CDOs, everything spun off or was derived from the rampant fraud in housing.

Posted by Michael Blomquist | Report as abusive

Join the Campaign To Cancel the Illegitimate Washington National Debt on Facebook at:
http://www.facebook.com/home.php?#/group .php?gid=67594690498&ref=ts

Posted by Ron | Report as abusive

http://moneyfinancetaxinvesting.blogspot .com/2009/10/monetary-policy.html

Basically what Rolfe is saying is that the Fed should mess with the markets expectations to build credibility. Usually when people mess with my expectations, their credibility decreases. I can understand how someone may want the Fed to take a more conservative approach with monetary policy, but I do not understand why it would build credibility if they did this when the market “least expects it.”