The Fed Loses Twice

The Fed lost twice tonight, in that it will face a more skeptical Congress, and that fiscal policy will be jammed for the next two years, meaning that so-called monetary policy will have to do more of the heavy lifting.

Bad timing for the Fed.  They are powerless, or even negatively powerful (They will achieve the opposite of what they are intending), because they don’t understand how monetary policy really works, particularly during times of crisis.

The Fed is imitating Japan, which has done horribly over the last 20 years.  Can’t they learn from recent data?  Interest rates that are too low cause businessmen to make bad decisions.

My advice to the Fed: raise rates.  You might be surprised to find that higher rates lead to greater employment. Economies don’t work well when there is no place for savers to park funds, or when investors don’t have an alternative to risk assets.  Economic agents don’t react well when crisis measures are used… it makes them sit on their hands all the more.  Nothing good ever comes from punishing the prudent, and rewarding the imprudent.  (And, I really fell sorry for seniors in this environment — their ability to generate income in an environment of QE is reduced.)

If the Fed is trying to create inflation, it will find that the creation of asset inflation in what they buy for QE is easy.  But where it goes after that is anyone’s guess.  Currency markets will reflect the debasement, and prices of things we import will rise, like oil, but until Ben buys the helicopter fuel and sends the imagined virtues of currency debasement to the people directly, rather than stealth-financing the government, the price rises of goods and services will be anemic.

But if goods price inflation comes, it may come more aggressively than expected, and be much harder to control than economists presently think.  We don’t have a good model for monetary policy, yet.  After all, consider the last 100 years.

  • Fed created to provide an elastic currency, so as to avoid another panic of 1907.
  • In response to a minor economic crisis ~1920, the Fed adopts a loose monetary policy, leading to a large buildup of debt, and then the Crash and the Great Depression.
  • By 1941, debt levels return to normal.
  • Post WWII, high inflation, but short-lived.  The Greatest Generation sucks it up, and accepts the high taxes necessary to pay down the war debts.  Their great error: not paying enough attention to child-rearing.  After all, they created the Baby Boomers, of which I am one.
  • Post WWII, the Fed is restrained an functions relatively well, until the ’60s when monetary looseness leads to foreign governments/central banks trading US Dollars for gold.
  • The Phillips curve is discovered, and someone decided to experiment with more inflation in exchange for higher employment.
  • Add in dissolving the final link the dollar has to gold under Nixon.
  • Alas, the result is stagflation — higher inflation and higher unemployment.
  • It takes an unorthodox and painful monetary policy from Volcker in the early ’80s to get ahead of the curve.  All rates rise; the short rates go through the roof; unemployment is higher then than today.  But the recovery is brisk.
  • Under Greenspan, a policy of letting the markets implicitly dictate monetary policy leads to The Great Moderation.
  • Looks like genius for a time, but the debt builds up to higher levels than during the Great Depression.

Now we deal with the aftermath.  During the bust there are no good solutions; the best one can do is expedite the compromising of debt, and move toward an equity based economy again.  The process is painful, but there is no free lunch.  If you want robust growth, you must allow recessions to do their work, and force marginal uses of capital out of business.

Instead, we adopt a policy that forces rates lower, favoring borrowers over savers, and leads to greater stagnation.  And all this from QE, a theory that is untested, and has not worked in Japan for two decades.  Letting academic economists, who don’t have a good handle on how monetary really works, run monetary policy is lunacy.  They didn’t get it right in the past.  They are not getting it right now.

More later today when I comment on the FOMC statement.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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