Friday, October 08, 2010

More Evidence of Unlearned Lessons At The Fed

Today's lead Wall Street Journal staff editorial, The "Limited Inflationists," was a real eye-opener.

In it, the author identified Sumner Slichter, a Harvard University economist in the 1950s, as the intellectual father of the notion that a little managed inflation is good for an economy.

Early on, the piece states,

"In a hearing on Capitol Hill, his views drew a famous rebuke from Fed Chairman William McChesney Martin, but Slichter's ideas gained currency in the 1950s and 1960s and eventually laid the groundwork for the not-so-gradual inflation of the 1970s.

Slichter died in 1959, but he is staging a rebirth at none other than Martin's former home, the Federal Reserve. A galaxy of Fed officials has fanned out to argue for another round of "quantitative easing," or a further expansion of the Fed balance sheet to boost the economy. The "limited inflationists" are once again at America's monetary helm, promising happier days from rising prices while downplaying the costs and risks."

The editorial then goes on to detail the various players on the Fed Open-Market Committee who are now targeting inflation levels, claiming there is wiggle room, because the actual rate of inflation is below their target, so a little more of it won't hurt.

The author offers some evidence that the QE2 planned to effect this inflation won't achieve very much for the $500B spent.

But the real message comes near the end of the editorial,

"The case for QE2 assumes that the problem with the economy is merely a lack of money. But trillions of dollars are already sitting unused on bank and corporate balance sheets. The real problem isn't lack of capital but a capital strike, as businesses refuse to take risks or hire new workers thanks to uncertainty over government policy, including higher taxes and regulatory burdens. More Fed easing in this environment risks "pushing on a string," adding money to little economic effect.

By keeping interest rates artificially low, the Fed is also contributing to a misallocation of capital and perhaps new asset bubbles. Messrs. Bernanke and Evans say they see no signs of inflation, as measured by the lagging indicator of the consumer price index."

These are both very important points.  Most informed observers of the current business situation understand that the author is correct. It's uncertainty with respect to governmental actions on many fronts that has immobilized capital and investment, not rate levels. And more bubbles and capital misallocation are likely, in a repeat of Greenspan's mistakes of the early years of the past decade.

"But investors are having no trouble bidding up the price of commodities, including oil and gold. A rising price of oil will have its own negative impact on growth, as we know from the experience of $147 oil in mid-2008. A commodity price spike might well erase any benefit from the expected decline of 15 basis points in long-term bond yields."

This is a particularly astute observation. Bernanke & Co. are running around announcing that, since the CPI and other baskets of goods aren't rising too fast in price, there's little inflation. They conveniently ignore the commodity bubbles now building. CNBC's Rick Santelli has noted this often in the past months.

Why is, in years past, Fed officials admitted, in hindsight, to asset pricing bubbles, but now, while observing them again, they choose to blithely ignore them and focus on more benevolent measures which are currently behaving to their liking?

Finally, the editorial delivers the coup de grace,

"As the protector of the world's reserve currency, the Fed also risks more global monetary disruption. The mere anticipation of QE2 has already caused Japan to pursue its own purchases of exotic assets, while Britain may do the same, as they and other countries try to avoid sharp rises in their currencies against the dollar. The European Central Bank may well have to follow, as the entire world adopts the "limited inflation" philosophy. In such a world, it's hardly surprising that gold has climbed in price against all major fiat currencies as a remaining store of value."

Forget all the foregoing technical points, if you wish. The argument which should trump all others is that of the Fed standing for price stability for the world's reserve currency. If it doesn't choose to do this, it is abdicating an important responsibility, and inviting further efforts to dethrone the dollar from this role.

That would be a mistake from which America, like Great Britain in the early 1900s, will probably never recover. Thus, the final paragraph of the piece,

"Which brings us back to Sumner Slichter and the limited inflationists. Amid the political and media interest in their ideas, Fed Chairman Martin appeared before the Senate Finance Committee. "There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions," the father of the modern Fed thundered, in a warning that would be vindicated after his retirement in 1970. That's a warning as well for the QE Street Band."

No kidding. Just ask Paul Volcker.

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