Reflections About the Fed on a Snowy Day

February 25, 2010

A key message of Fed Chairman Bernanke’s testimony this week has been that while improved financial market functionality warrant the gradual unwinding of unconventional measures, the economy is not ready for outright monetary tightening.  It may be an “extended period” before such a time arrives.  The point is not that the recovery that saw GDP advance 5.7% last quarter is not genuine.  Rather, positive growth remains highly dependent upon policy support — fiscal as well as monetary — and could evaporate if the punch bowl is withdrawn soon.  It’s a message shared by most central banks in other advanced economies.

What if years pass before the U.S. economy can handle tighter policy?  That’s a big concern of mine, having watched that precise scenario unfold in Japan.  The U.S. upturn clearly has stress fractures.  Yesterday’s news of an 11.2% plunge in new home sales last month and a 26.3% drop over the last half-year to a record low highlights one of them in the housing sector.  Today’s jobless insurance claims put the focus on another.  New claims last week of nearly a half million workers were 60 thousand greater than in the week to Christmas, and the upward trend at such elevated levels during recent weeks is a pattern normally associated with recessions, not recoveries.

It’s one thing for GDP to trend upward but another for private demand to do so without policy encouragement.  That’s what is meant when officials say that a self-sustaining upward business cycle is still not assured.

Both the Bush43 and Obama administrations have been criticized for reacting to the Great Recession with massive stimulus whose legacy may burden future generations.  It can never be known for certain what would have happened if a hands-off approach had been tried instead.  Some believe in the intrinsic self-healing powers of markets.  With the right infrastructure of laws to promote competition and property rights, all one needs is time for non-inflationary growth and a return to full employment to occur.  I do not share such confidence especially amid an initial financial market shock, which many authorities including Alan Greenspan, call more severe than what transpired in 1929-32.  Concerns about the budget deficit and a loose monetary policy surfaced back then too, and the instincts to preserve the gold standard and balance the budget seem very ill-conceived through the lens of hindsight.  Many other instances in history can be found when long-term market equilibrium also persisted below full employment.

The Fed’s critics are on a mission to curtail its powers.  For some this is limited to banking supervision.  For others, like Congressman Ron Paul, it goes to the heart of monetary policymaking and even to whether the existence of a central banking institution does more harm than good.  The greatest American critic of central banking was arguably the seventh president, Andrew Jackson, whose picture ironically adorns the $20 Federal Reserve note.  After Jackson allowed the the charter of the Second Bank of the United States to expire in 1836, 77 often-disorderly years in U.S. banking ensued.  Standards of prudent management were forgotten, and the number of banks and amount of bank credit proliferated at a cancerous rate.   The economy suffered numerous wrenching depressions, panics and recessions, beginning with the panic of 1937 when business activity plunged 32.8% and over 600 banks failed.

The corruption of price stability when politicians are allowed to influence monetary policy is well-documented.  Here’s one example.  In the 23 years between December 1973 and December 1996, British retail prices rose 8.2% per annum, while inflation averaged 5.8% in the United States and 3.2% in Germany.  The British Treasury, not the Bank of England, had authority over interest rate decisions in that period.  The Fed as now had dual goals of preserving low, predictable and stable inflation but also of promoting job and economic growth.  The German Bundsbank only a single objective, complete independence and the confidence of the people.  Not surprisingly, Germany took the gold medal in inflation fighting.  In May 1997, the Bank of England was vested with exclusive power to run monetary policy.  In the nine years between December 2000 and December 2009, inflation in Britain of 2.1% per annum was identical to inflation in the euro area, and that pace was 0.4 percentage points lower than the U.S. CPI inflation rate.  Four-tenths seems an acceptable tradeoff for a Fed policy that contributed to faster growth in the United States than in Europe.  The Fed’s hands are not clean in allowing the Great Recession, just at it bore partial responsibility for the Great Depression.  But proposed modifications would be making an imperfect situation most likely a lot worse.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



2 Responses to “Reflections About the Fed on a Snowy Day”

  1. Jimbo says:

    While are people debating about the power of the FED? It is more of a “nothing burger”. They raised the discount rate by 1/4% to banks who are not borrowing much money anymore. Please explain how this affects anyone. I think interest rates are staying low for a long time if this is a “bold move” by the FED!

  2. ljgreen says:

    The Fed is an authority figure, and some people will distrust the intentions of any authority figure. The Fed’s discount rate hike was not inconsequential, but neither must it raise interest rates. It was one of many technical steps that need to be taken before a rise in interest rates can be implemented. The discount rate is a penalty rate and in ordinary times is about a full percentage point higher than the fed funds target, which is the rate at which banks lend to one another and which anchors the structure of short-term interest rates. The 0.75% DR is still only half a percentage point above the FF rate. While a discount rate hike has no direct impact on short-term rates, the timing of such a move and whether it changes the view of investors about how soon the Fed might actually begin lifting its fed funds target can impact longer-term interest rates.