The Fed, the Wall Street Journal is reporting, wants to outline an exit strategy from its policy of monetary easing that was undertaken in response to the crisis. It wants to publicly think about how to take the money back to the burn bin as the economy recovers sustainably to communicate that it is not asleep at the wheel either on inflation or stagflation, given all the rumbling about the Fed’s money supply causing the crisis.
After all the hullabaloo about the Bernanke confirmation recently, some revealing confusion appears to have surrounded the Fed as to who may be really running the place out of its Board room. The young, well-connected and perhaps anointed Harvard MBA governor Kevin Warsh, or the monetary policy scholar chairman of the Fed, Ben Bernanke.
The overarching sentiment to keep inflation under wraps and stagflation at bay, after the recent monetary deluge which is not quite enough if the country gets down to growing again and enough if it wants to return to the status quo before the crisis, is somehow not consistent with the underlying policy mechanisms to achieve that goal. It seems as though the Board is delegating the mechanics of policy to the plethora of outsiders such as ― the New York financial firm Blackrock, a recent inside-outside-inside entrant into the Federal Reserve Bank of New York, a former Board economist named Brian Sack who had a stint at a D.C-based economic forecast firm called Macroeconomic Advisers founded by a former Fed governor Lawrence Myers whose forecast the FOMC takes seriously in its deliberations, and to the Fed’s own bevy of Ph.Ds, as if to say: here is the goal, you figure out how to get it done. It feels like the Bush White House until all hell breaks loose.
The focus of the institution seems to be tactically shifting inward, handled by its Congressional handlers to guide the thrust of the policy advice the Federal Open Market Committee (FOMC) is receiving to keep the institution unscathed and intact as the economy emerges from this crisis. Bernanke is courting the economists and Warsh the markets to prevent any reforms that could diminish the scope of the Fed. And all of this, of course, with the full support, if not the advice and consent, of the White House, the Treasury and the National Economic Council (NEC).
The economic assumptions of the economic recovery forecast, as explicated by Bernanke on CBS’ 60 minutes, seem to be to achieve a growth rate of about 2 per cent and inflation somewhere between 3.5 per cent to 5 per cent to let that growth rate be self-sustainable under normal monetary conditions, meaning at a federal funds rate somewhere between 3.5 per cent and 5 per cent. The level of unemployment is implicit to the Fed’s forecast, but based on what is being echoed around Washington, it can be expected to be anywhere between 7.5 and 8.5 per cent by 2011. The goal seems to be to avoid stagflation and achieve recovery to claim victory before the 2012 re-election campaign, perhaps impressed upon by Paul Volcker’s experience, and to put off any reforms if they are avoidable. The trade-off being made seems to be slower growth and high unemployment in exchange for preventing stagflation. The President seems to be working on wooing the country into expecting and living with the new normal on the economy for the foreseeable future.
Meanwhile, the people who must give their advice and consent about appointees to the Fed Board, the United States Senate, and particularly Senators Dodd and Shelby, are being strong-armed into irrelevance, given Senator Dodd’s impending retirement and Senator Shelby’s minority status. Executive power over the U.S economy is in full bloom, but Vice President Joe Biden’s 2009 economic spring is still being battered by the Washington winter. If the government’s economic team is the New York Yankees, the team work is so perfect that they would be “winning” a losing game, playing defense.
Paying interest on the excess reserves at a rate that could creep up closely tracking the federal funds rate once it begins to rise, the Fed will not only be withdrawing money but making it more expensive to borrow than when the interest rate on the excess reserves is zero, because those member banks with excess reserves, whatever the federal funds rate, would not want to lend to collect the overnight lending rate if they can earn the same every night by leaving it in their Fed accounts. Further, as a consequence, when the banks do not want to lend artificially tightening the supply of federal funds putting an upward pressure on the federal funds rate relative to the Fed’s target, the Fed will have to raise money supply to target its desired rate as a matter of monetary operations to keep the rest of the cascading interest rates in the market at their corresponding levels. Meaning, the banks, on the one hand have the incentive to not lend their excess reserves, and on the other, charge lending rates as determined by the Fed’s target because the quantity of base money keeps rising to maintain that target because the banks are reluctant to lend to each other on an overnight basis. In effect, the Fed is expecting to offset income loss to the banks due to the slower economy with interest payments on excess reserves. And all of this to support the objective of reforming nothing.
The risk, however, is that the Fed could once again cause deflation by trying to prevent stagflation and to help the government avoid meaningful reforms because the administration’s goal of boosting the country’s exports through the cheap dollar is the equivalent of the tail wagging the dog of the U.S economy if reforms are not taken up both at the Fed and elsewhere to raise the economy’s potential growth rate through higher, forward-looking domestic investment to return the country’s employment, wages and personal savings situation to robust health.
This president, like his predecessor, is very goal-oriented. Even if he does not run again, he seems to want to be able to say that he was handed a lousy economic situation and he put it back on the path of self-sustainability as he had promised, albeit at a lower growth rate and a persistently higher-level of unemployment. The debt, to him, is the justifiable cost of that recovery to cushion the society through a more expansive social safety net.