The Fed Under Fire

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Now, on to the Fed…

There are several key issues concerning the Fed that you should be thinking about.  Most of these issues can be divided into two categories: (1) the politicization of the Fed; and (2) concern over monetary policy.  Here’s a quick review of the issues:

Part 1: The Politicization of the Fed

1. Congress has a bill pending which would allow oversight of the Fed’s monetary policy decisions.  The bill would grant the GAO audit authority over the Fed.  This effort has been led by Ron Paul and he has found 307 co-sponsors for his bill. Bernanke has argued that politicizing monetary policy would result in the markets losing confidence in the Fed.  He has argued that studies prove that independent central banks are able to keep inflation and interest rates lower (than banks which are not independent).

My personal view can be summed up this way: if 308 Congressmen think something is a good idea, it probably isn’t.  If the Fed loses its independence, this will likely be the single most costly result of the financial crisis.  The idea of politicizing monetary policy should scare the hell out of you.  Regardless of past mistakes, most investors tend to trust that the Fed is wholeheartedly attempting to fulfill its dual mandate: promoting full employment and maintaining low inflation.  We know the view of politicians – they always want lower rates.  If investors believe that the Fed will not fight inflation, we’re all going to pay for it in the form of higher interest rates (which result from inflation fears).

2. As a result of past failures, there is significant discussion about taking away the Fed’s regulatory powers.  Bernanke is fighting this and has argued that the Fed gains information and expertise (through their regulatory function) and this aids the Fed in setting monetary policy and promoting stability.  Bernanke has said that the Fed needs to understand the collateral and solvency of banks if they (the Fed) are going to be able to make emergency loans.

My personal view is there have been a tremendous number of failures in our regulatory system – whether you look at the Fed, the FDIC or the SEC.  Creating a separate government entity will lead to the same people switching agencies and we will have the same problems.  In addition, I do agree with Bernanke’s comments – it’s hard for the Fed to be the lender of last resort if the Fed is not completely immersed in the banking system.

3. Senator Dodd is trying to eliminate the ability of regional Federal Reserve banks to nominate their board Chairmen.  Instead, he wants this to be a Presidential appointment.  This is just further evidence that we need to always be wary of legislation proposed by politicians in heated political re-election campaigns.  Again, we’re seeing a desire to politicize functions that, in rational times, we concluded needed to be separated from the political process.

4. Bernanke has been testifying before the Senate Banking Committee as he tries to gain confirmation for his re-appointment to a second term.  His current four year term expires at the end of January.   The last Fed chairman to encounter significant opposition was Paul Volcker.  Politicians were angry after Volcker raised interest rates to try to lower inflation.  In my opinion, this pretty much says it all.  Volcker is an economic hero and politicians (who are economic villains) will always line up against raising interest rates.

I would love to see Senate / Congressional hearings on Senators and Representatives.  I’d love to ask them what they think is going to happen when we continue to run deficits.  I’d really like to know how they think we can handle the unfunded liabilities associated with Medicare / Medicaid, Social Security and Veterans Affairs.  Watching these guys grill Bernanke would be like watching Tiger Woods interrogate Elliot Spitzer about his use of prostitutes.

Part 2: Monetary Policy Issues

1. The Fed’s balance sheet has more than doubled (from $800 billion of assets before the crisis to $2.2 trillion of assets now) and now there are $1 trillion of excess reserves in the banking system.  In other words, banks are holding an extra trillion dollars that they could potentially loan out.  There is a fear that if this money is loaned out, there could be inflation.  There is equal fear that it will be impossible for the Fed to remove these excess reserves from the system without slowing the economy.  (It’s been reported that they will try to remove this liquidity in the future through the use of “reverse repos.”)

My personal view is that we’re in unchartered territory and I have no idea concerning how difficult this process will be.  We’re in a state of conflict right now: we want banks to lend, but we want them to be more cautious.  We want banks to lend, but we don’t want inflation.  We want the Fed to remove the risk of inflation (and eliminate the excess reserves) but we don’t want them to slow the economy.

2. There is discussion of whether the Fed should consider “popping bubbles” as part of its role.  Greenspan argued that this was not the Fed’s job during the tech bubble.

My personal view is that during the tech bubble, we said that bubbles are a “once-in-a-lifetime” event – so we didn’t worry about the issue of whether bubbles should be popped.  It turns out that the “once-in-a-lifetime” thought was right, it’s just that we were talking about the life expectancy of a fruit fly.   It’s easy to argue that we followed the tech bubble with a credit and housing bubble.  Money flows around the globe so quickly, chasing returns, that we realize that we need to worry about future bubbles.

The problem with popping a bubble is that it’s difficult to do so without hurting other parts of an economy.  In addition, it’s difficult to assume that regulators will be able to accurately identify bubbles.

I read one commentator state that one of the events that we experience with bubbles is that the increased value of assets is used as collateral for loans that are used to fuel further speculation (increasing the bubble).  If the Fed is going to pop bubbles, regulating collateral and lending is probably a much better tool than simply raising interest rates.  But again, that doesn’t make it easy to do.

3. Lower interest rates may be resulting in the “carry trade” – where investors borrow dollars cheaply, convert the dollars to another currency and invest at higher interest rates.  In addition, there’s a belief that low rates are resulting in money flowing into riskier assets (stocks, corporate bonds and commodities).

We’re all watching to see what happens when the Fed raises interest rates.  While we all want stronger economic growth and more employment, there is a fear that these events will lead to the Fed raising rates and that will result in the “unwinding of the carry trade.”  This may be why we saw the dollar rise and gold fall ($50) after the employment number came in stronger than expected.

In sum, I always describe the Fed in the same way that I once overheard Jenny describing me (to a friend).  I heard her say, “he’s not much, but he’s all I’ve got.”  I think that’s fair and I think that’s how I feel about the Fed.  The Fed is far from perfect.  The Fed’s problems pre-date Bernanke.  But, if we start to further politicize the Fed, there will be long term repercussions that will dwarf the problems that we already have.

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