Ten Notes on Our Funky Federal Reserve
1) Fed chatter has gotten a little quieter, so maybe it is time for an update. Let me begin by saying in an era of detailed press releases from the Fed, many analysts spend more time parsing phrases than looking at the quantitative guts of monetary policy. This article from Mish, which cites this article from Gary North is close to my views, in that they are looking at what is happening to the critical variables of the money supply.
2) For another example, Look at the discount window. That has faded as a factor over the past two weeks. You have to dig into Dow Jones Newswires just to hear about this. The discount window is back to being a non-entity.
3) Review his book. Cite his article. Though I think the FOMC will loosen more, I agree that it should not be loosening. The Fed will overstimulate healthy areas of the economy, while sick areas get little additional credit; that’s how fiat monetary policy works. (Maybe I should review James Grant’s The Trouble With Prosperity?)
4) I may not vote for him, but I like Ron Paul. He is one of the few economically literate members of Congress. Thus I enjoyed his question to Ben Bernanke. I favor a sound dollar, and risk in our system. It keeps us honest. Without that, risk taking gets out of control.
5) Now, onto the chattering Fed Governors. Consider Donald Kohn, a genuinely bright guy trying to spin the idea that the Fed is not to blame for residential real estate speculation. He argues that much of the speculation occurred while the FOMC was tightening. Sorry, but the speculation only cut of when the FOMC got rates above a threshold that deterred speculation because positive carry from borrowing to buy real estate disappeared, which finally happened in September of 2005, when the FOMC was still tightening.
Or, consider Fed Governor Frederic Mishkin, who thinks that troubles in the economy from housing can be ameliorated by proactive FOMC policy. If his view is dominating the Fed, then my prediction of 3% fed funds sometime in 2008 is reasonable.
But no review of Fed Governor chatter would be complete without the obligatory, “Don’t expect more rate cuts.” They don’t want their policy moves to be impotent, so they verbally lean against what they are planning on doing. This maximizes surprise, which adds punch to policy moves.
6) Consider foreign central banks for a moment. I’ll probably write more about this tomorrow, but a loosening Fed presents them with a problem. Do they let their currencies appreciate, slowing economic growth, or do they import inflation from the US by cutting rates in tandem? Tough decision, but I would take the growth slowdown.
7) What central bank has had a rougher time than the Fed? The Bank of England. When push came to shove, they indicated that they would bail out a large portion of the UK banking system. Northern Rock financed a large part of their assets via the Bank of England during their crisis. This just sets up the system for greater moral hazard in the future.
Now the CP market is returning to health; almost all of the questionable CP has been refinanced by other means. Now, money market funds are better off than they were one month ago, but all of the issues are not through yet. Some money market funds contain commercial paper financing subprime CDOs. Now, the odds are that the big fund sponsors would never let the ir funds break the buck. They would eat the loss. That’s not a certainty though so be aware.
9) This article is the one place where the Fed lists most of the Large Complex Banking Organizations [LCBOs -- pages 32-33]. Some suggest that this is the “too big to fail list,” though by now, it is quite dated. On the bright side, it correlates highly with asset size, so maybe a list of the 20 largest bank holding companies in the US would serve as well.
10) We end with Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” My way of saying it is that trying to control a system changes the system. The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.
October 4th, 20072:26 pm at
David,
Really like the piece on the Fed, especially the application of Goodhart’s Law, although I word it slightly differently than you - why try and artificially create a “sound money” system with fiat money, when we could actually have a sound money system?
Anyway, I also wanted to delve for a second into
a taboo area - Ron Paul. You suggest that though you might like him, you may not vote for him. Is there another candidate who you feel would better represent our interests in the pursuit of sound money? I guess I just assumed that you would support his candidacy and was surprised to see that you might not.
Keep plugging away at tbe Funky Fed,
Jason
October 4th, 20072:52 pm at
To Ron Paul supporters: I had not realized that I had crossed a trip-wire when I mentioned point 4. I have corresponded with Ron Paul is the past over Gold (he used to deal in it), and over M3.
There are limits to what any one man can do to preserve the Constitution. Without a supportive Congress or court system, the Constitution will continue its slow death. Why? Because a large enough fraction of the American people don’t care any more, and are willing to give up freedom for seeming security. There is a bigger cultural problem around our political problems that politics cannot solve.
This is not a politics blog, largely because my views are nonstandard, and would not get a lot of credence.
As for sound money, I am all for it, but even gold standards get compromised, usually by the governments that benefited from them at one point. Sound money is easy to propose, but hard to maintain.
October 4th, 20073:48 pm at
I would like to know why a gold producer cartel consisting of Russia, South Africa, and Canada (for starters) couldn’t mess with the value of a gold based currency just as badly as the Fed messes with our fiat currency.
October 4th, 20076:11 pm at
Hello David,
Interesting you posted the Mish piece. I almost put a link to it in the comments to one of your posts last week.
I am having a very hard time wrapping my mind around the implications of that piece. I suspect I am not alone. There seems a lot of arm-chair Fed Governoring going around the blogoshpere on this topic and very little of it I find compelling. Any posts you could offer clarifying the topic would be very much appreciated.
For starters if I may, what I think Mish’s piece is saying is that the Fed is trying to stop a credit induced deflation with a lowering of interest rates, yet by being careful not to grow money supply, they presumably hope to avert inflation as a side-effect. Is that correct?
Countering that is the opinion expressed by some here that once a credit bubble’s formed, deflation cannot be averted when it pops. Thus the Fed is bound to induce inflation as they keep pushing on a rope as it were. And that’s why the dollar has been sinking. (Or is dollar depreciation a red-herring and simply an artifact of our current account defecit?) But how do we get from deflation to inflation, or is it from inflation to deflation? This is where my head starts to hurt.
Finally, fwiw, my take away from an investment perspective is that if one believes the Mish argument, then keep in shortish/intermediate bonds and a few select stocks as the dollar devaluing and inflating that is inevitable will keep the stock market juiced in the short-term. Short-term being a few months, perhaps going into the election cycle, but maybe less. If that is the wrong strategy for dealing with the monetary policy described by Mish et al, please offer corrections.
Best,
-Allan