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FT.com The Economists’ Forum: Why Washington’s rescue cannot end the crisis story

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Why Washington’s rescue cannot end the crisis story



by Martin Wolf

Last week’s column on the views of New York University’s Nouriel Roubini (February 20) evoked sharply contrasting responses: optimists argued he was ludicrously pessimistic; pessimists insisted he was ridiculously optimistic. I am closer to the optimists: the analysis suggested a highly plausible worst case scenario, not the single most likely outcome.

Those who believe even Prof Roubini’s scenario too optimistic ignore an inconvenient truth: the financial system is a subsidiary of the state. A creditworthy government can and will mount a rescue. That is both the advantage – and the drawback – of contemporary financial capitalism.

Any government with its own non-convertible currency can readily support nominal domestic aggregate demand at any desired level and, for example, sustain full employment as desired.

The ‘risk’ is ‘inflation’ as currently defined, not solvency.

In an introductory chapter to the newest edition of the late Charles Kindleberger’s classic work on financial crises, Robert Aliber of the University of Chicago Graduate School of Business argues that “the years since the early 1970s are unprecedented in terms of the volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises”*. We are seeing in the US the latest such crisis.

Yes, price volatility has seemingly substituted for output gap volatility.

All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado.

With floating fx/non-convertible currency ‘capital inflows’ do not exist in the same sense they do with a gold standard and other fixed fx regimes.

This generates low real interest rates and a widening current account deficit.

The current account deficit is a function of non-resident desires to accumulate your currency. These desires are functions of a lot of other variables.

Non-residents can only increase their net financial assets of foreign currencies by net exports.

This is all an accounting identity.

Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.

With variations, this story has been repeated time and again. It has been particularly common in emerging economies. But it is also familiar to those who have followed the US economy in the 2000s.

The US did not get here by that casual path.

Foreign CB accumulation of $US financial assets to support their export industries supported the US trade deficit at ever higher levels.

The budget surpluses of the late 1990s drained exactly that much net financial equity from then non-government sectors (also by identity).

As this financial equity that supports the credit structure was reduced via government budget surpluses, non-government leverage was thereby increased.

This meant increasing levels of private sector debt were necessary to sustain aggregate demand as evidenced by the increasing financial obligations ratio.

Y2K panic buying and credit extended to funding of improbably business plans came to a head with the equity peak and collapse in 2000.

Aggregate demand fell, GDP languished, and the countercyclical tax structure began to reverse the surplus years and equity enhancing government deficits emerged.

Interest rates were cut to 1% with little effect.

The economy turned in Q3 2003 with the retroactive fiscal package that got the budget deficit up to about 8% of GDP for Q3 2003, replenishing non-government net financial assets and fueling the credit boom expansion that followed.

Again, counter cyclical tax policy began bringing the federal deficit down, and that tail wind diminished with time.

Aggregate demand was sustained by increasing growth rates of private sector debt, however it turns out that much of that new debt was coming from lender fraud (subprime borrowers that qualified with falsified credit information).

By mid 2006, the deficit was down to under 2% of GDP (history tells us over long periods of time we need a deficit of maybe 4% of GDP to sustain aggregate demand, due to demand ‘leakages’ such as pension fund contributions, etc.), and the subprime fraud was discovered.

With would-be-subprime borrowers no longer qualifying for home loans, that source of aggregate demand was lost, and housing starts have since been cut in half.

This would have meant negative GDP had not exports picked up the slack as non-residents (mainly CBs) stopped their desire to accumulate $US financial assets. This was Paulson’s work as he began calling any CB that bought $US a currency manipulator and used China as his poster child. Bernanke helped with his apparent ‘inflate your way out of debt/beggar thy neighbor policy’. Bush also helped by giving oil producers ideological reasons not to accumulate $US financial assets.

Our own pension funds also helped sustain GDP and push up prices with their policy of allocating to passive commodity strategies as an asset class.

The fiscal package will add about $170 billion to non-government net financial assets, and non-residents reducing their accumulation of $US financial assets via buying US goods and services will also continue to help the US domestic sector replenish its lost financial equity. This will continue until domestic demand recovers, as in all past post World War II cycles.

When bubbles burst, asset prices decline, net worth of non-financial borrowers shrinks and both illiquidity and insolvency emerge in the financial system. Credit growth slows, or even goes negative, and spending, particularly on investment, weakens. Most crisis-hit emerging economies experienced huge recessions and a tidal wave of insolvencies. Indonesia’s gross domestic product fell more than 13 per cent between 1997 and 1998. Sometimes the fiscal cost has been over 40 per cent of GDP (see chart).

Yes, interesting that this time with the boom in resource demand, emerging markets seem to be doing well.

By such standards, the impact on the US will be trivial. At worst, GDP will shrink modestly over several quarters.

Yes, that is the correct way to measure the real cost. Still high, as growth is path dependent, but not catastrophic.

The ability to adjust monetary and fiscal policy insures this. George Magnus of UBS, known for his “Minsky moment”, agrees with Prof Roubini that losses might end up as much as $1,000bn (FT.com, February 25). But it is possible that even this would fall on private investors and sovereign wealth funds.

Those are nominal losses: rearranging of financial assets. The real losses are the lost output/unemployment/etc.

In any case, the business of banks is to borrow short and lend long.

Not US banks – that’s called gap risk, and it’s highly regulated.

Provided the Federal Reserve sets the cost of short-term money below the return on long-term loans, as it has for much of the past two decades, banks can hardly fail to make money.

As above. In fact, with low rates, banks make less on free balances.

If the worst comes to the worst, the government can mount a bail-out similar to the one of the bankrupt savings and loan institutions in the 1980s. The maximum cost would be 7 per cent of GDP.

Again, that’s only a nominal cost, a rearranging of financial assets.

That would raise US public debt to 70 per cent to GDP and would cost the government a mere 0.2 per cent of GDP, in perpetuity.

Whatever that means..

That is a fiscal bagatelle.

Because the US borrows in its own currency,

Spends first, and then borrows to support interest rates, actually

(See Soft Currency Economics.)

it is free of currency mismatches that made the balance-sheet effects of devaluations devastating for emerging economies.

True. ‘External debt’ is not my first choice for any nation.

Devaluation offers, instead, a relatively painless way out of a slowdown: an export surge.

Wrong in the real sense!

Exports are real costs; imports are real benefits. So, a shift as the US has been doing is actually the most costly way to ‘fix things’ in real terms.

And it’s obvious the real standard of living in the US is taking a hit – ‘well anchored’ incomes and higher prices are cutting into real consumption that’s being replaced by real exports/declining real terms of trade, etc.

Between the fourth quarter of 2006 and the fourth quarter of 2007, the improvement in US net exports generated 30 per cent of US growth.

Yes, we work and export the fruits of our labor. In real terms, that’s a negative for our standard of living.

The bottom line, then, is that even if things become as bad as I discussed last week, the US government is able to rescue the financial system and the economy. So what might endanger the US ability to act?

The biggest danger is a loss of US creditworthiness.

Solvency is never an issue. I think he recognizes this but not sure.

In the case of the US, that would show up as a surge in inflation expectations. But this has not happened. On the contrary, real and nominal interest rates have declined and implied inflation expectations are below 2.5 per cent a year.

I think they are much higher now, but in any case, inflation expectations are a lagging indicator, and in my book cause nothing.

An obvious danger would be a decision by foreigners, particularly foreign governments, to dump their enormous dollar holdings.

The desire to accumulate $US financial assets by foreigners is already falling rapidly, as evidenced by the falling $ and increased US exports. The only way to get rid of $ financial assets is ultimately to ‘spend them’ on US goods, services, and US non-financial assets, which is happening and accelerating. Exports are growing at an emerging market like 13% clip and heading higher.

But this would be self-destructive. Like the money-centre banks, the US itself is much “too big to fail”.

Statements like that make me think he still has some kind of solvency based model in mind.

Yet before readers conclude there is nothing to worry about, after all, they should remember three points.

The first is that the outcome partly depends on how swiftly and energetically the US authorities act. It is still likely that there will be a significant slowdown.

If so, the tax structure will rapidly increase the budget deficit and restore aggregate demand, as in past cycles.

The second is that the global outcome also depends on action in the rest of the world aimed at sustaining domestic demand in response to a US shift in spending relative to income. There is little sign of such action.

True, budget deficits are down all around the world except maybe China and India, especially if you count lending by state supported banks, which is functionally much the same as government deficit spending.

The third point is the one raised by Harvard’s Dani Rodrik and Arvind Subramanian, of the Peterson Institute for International Economics in Washington DC, (this page, February 26), namely the dysfunctional way capital flows have worked, once again.

I would broaden their point. This is not a crisis of “crony capitalism” in emerging economies, but of sophisticated, rules-governed capitalism in the world’s most advanced economy. The instinct of those responsible will be to mount a rescue and pretend nothing happened. That would be a huge error.

Those who do not learn from history are condemned to repeat it.

And those who keep saying that seem to be the worst violators.

One obvious lesson concerns monetary policy. Central banks must surely pay more attention to asset prices in future. It may be impossible to identify bubbles with confidence in advance. But central bankers will be expected to exercise their judgment, both before and after the fact.

While asset prices are probably for the most part a function of interest rates via present value calculations, my guess is that other more powerful variables are always present.

A more fundamental lesson still concerns the way the financial system works. Outsiders were already aware it was a black box. But they were prepared to assume that those inside it at least knew what was going on. This can hardly be true now. Worse, the institutions that prospered on the upside expect rescue on the downside.

I’d say demand rather than expect. Can’t blame them – whatever it takes – profits often go to the shameless.

They are right to expect this. But this can hardly be a tolerable bargain between financial insiders and wider society. Is such mayhem the best we can expect? If so, how does one sustain broad public support for what appears so one-sided a game?

Watch it and weep.

Yes, the government can rescue the economy. It is now being forced to do so. But that is not the end of this story. It should only be the beginning.

‘should’ ???

Fiscal costs of bank bailouts

US yield curve

US inflation expectations

* Manias, Panics and Crashes, Palgrave, 2005.

martin.wolf@ft.com

February 27th, 2008 in US economy | Permalink

4 Responses to “Why Washington’s rescue cannot end the crisis story”

Comments

  1. Kent Janér (guest): Largely, I agree with Martin Wolf’s analysis of what went wrong and what should be done in the future to prevent the by now very familiar pattern of boom and bust in regulated financial systems.There is one aspect that I think merits more attention than it has been given, an aspect that also has some important short term effects – the equity base of the financial system. I think the equity base is currently being mismanaged, and regulators could have some tools to improve the situation.

    As everyone knows, there are much more losses in the financial system than have so far been declared. I think close to USD 150 bn has been reported at this stage. That could be compared to for example the G7 comment of 400 bn in mortgage related losses, and 400-1000 bn in total losses probably covering most private sector forecasts. At the same time new risk capital has been raised to the tune of roughly 90 bn USD (ballpark number).

    A back of the envelope calculation shows that a large part of the equity of the financial system has been wiped out, much more than has been reported. The market knows, the regulators know and the banks themselves certainly know that even though they are far from bankrupt, they are on average in truth operating at equity/capital adequacy ratios clearly below both legal requirements and sound banking practices.

    Currently, the banks are responding by reporting losses little by little, keeping up the appearance of reasonable capitalization. At the same time, they try to reduce their balance sheet, especially from items that carry a high charge to capital. This way they hope (but hope is never a strategy) that time will heal their balance sheet; earnings will over time be able to offset continued writedowns. High vulnerability to negative surprises, but no formal problems with minimum capital adequacy ratios and control of the bank, “only” weak earnings for some time.

    That is all very nice and cosy for bank´s directors, but not for the economy in general. If a small part of the banking sector has specific problems and rein in lendig, so be it. That probably has little impact on the rest of the economy. However, if the entire financial sector postpone reported losses and contract their balance sheet, that is another question altogether. The cost to rest of the economy could be very high indeed.

I am less concerned about ‘loanable funds’ with today’s non-convertible currency. I see the issues on the demand side rather than the supply side of funding. Capital ’emerges’ endogenously as a supply side response to potential profits. The reducing lending is largely a function of increased perception of risks.

So, what should be done? Pretending that banks are OK and sweat it out over time is dangerous to economy as a whole, but so is being too harsh on the banks right now.

I actually think there is an answer – the banks should be made to recapitalize quickly and aggressively. Accepting new equity capital would minimize social cost of their current mistakes. There is an obvious practical problem with that, the price at which that capital is available is not necessarily the price at which current shareholders want to be diluted. So, in essence, the banking system continues to push the cost of their mistakes to others by not coming clean on their losses and recapitalize, rather they try to muddle through by not declaring their losses in full and pull in lending to the rest of the economy.

You hit on my initial reaction here. It’s up to the shareholders to supply market discipline via their desire to add equity, and it’s up to the regulators to make sure their funds – the insured deposits (most of the liability side, actually, when push comes to shove) – are protected by adequate capital and regulated bank assets. I think they are doing this, and, if not, the laws are in place and the problem is lax regulation.

I think regulators should be tougher here, banks that clearly are below formal capital adequacy ratios with proper mark to market should be armtwisted to accept new money.

Yes, as above.

I am also looking with dismay on the fact that even some of the weaker banks are still paying dividends to their shareholders – on a global scale I think the financial system has paid out more in dividends since the start of the crisis than they have raised in new capital.

Also, a regulatory matter. Regulators are charged with protecting state funds that insure the bank liabilities.

My proposals have been to not use the liability side of banks for market discipline. Instead, do as the ECB has done and fund all legal bank assets for bank in compliance with capital regulations.

So, a likely situation is that banks with failed business models in the first part of the crisis distribute capital to their owners and somewhat later asks the taxpayer for help…

Kent Janer runs the Nektar hedge fund at Brummer & Partners AB in Sweden Posted by: Kent Janér | February 27th, 2008 at 3:06 pm |

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Kohn speech

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After the speech, crude up $1.61 and back over $100.
Yields down on fixed income as markets anticipate Fed won’t respond to inflation anytime soon:

February 26, 2008

The U.S. Economy and Monetary Policy

(SNIP)

Several major developments are shaping current economic performance, the outlook, and the conduct of monetary policy. The most prominent of these developments is the contraction in the housing market that began in early 2006. Both the prices and pace of construction of new homes rose to unsustainable levels in the preceding few years. For a time, the resulting correction was largely confined to the housing market, but the consequences of that correction have spread to other sectors of the economy.

The financial markets are playing a key role in the transmission of the housing downturn to the rest of the economy.

(SNIP)

The result has been a substantial tightening in credit availability for many firms and households.

At the same time, continued sizable increases in the prices of food, energy, and other commodities have raised inflation. To some extent, those increases have resulted from strong demand in rapidly growing emerging-market economies, like China and India. But the increases likely also reflect conditions such as adverse weather in some parts of the world, the use of agricultural commodities to produce energy, and geopolitical developments that threaten supplies in some petroleum-producing centers. The higher prices have eroded the purchasing power of household income, adding to restraint on spending.

(SNIP)

Recent Economic and Financial Developments

The pace of real economic activity stepped down sharply toward the end of last year and has remained sluggish in recent months. Real gross domestic product (GDP) is estimated to have risen only slightly in the fourth quarter. The contraction in the housing market continues to drag down economic growth. Declines in real residential investment subtracted nearly 1 percentage point from the overall increase in real GDP in 2007. Even so, the inventory of unsold new homes remains unusually high, because the demand for housing has fallen about as rapidly as the supply. Problems in the subprime market have virtually cut off financing in this sector. Prime jumbo mortgages are being made, but the lack of a secondary market has caused the spread between rates on these mortgages and on those that have been eligible for purchase by Fannie Mae and Freddie Mac to widen substantially. Even the standards for conforming mortgages have been tightened of late. Weak demand, in turn, is leading to widespread declines in the actual and expected prices of houses, further discouraging buyers. Starts of new single-family homes continued to fall in January, dropping to fewer than 750,000 units–a level of activity more than 1 million units below the peak in early 2006. Judging from the further decline in permits last month, additional cutbacks in construction are likely. It appears that the correction in the housing market has further to go.

For the better part of the past two years, the trouble in the housing market was contained; however, over the past several months, the weakness appears to have spread to other sectors of the economy. Tighter credit, reductions in housing and equity wealth, higher energy prices, and uncertainty about economic prospects seem to be weighing on business and household spending. Labor demand has softened in recent months. Private nonfarm payrolls were little changed in January, and the unemployment rate moved up to 4.9 percent, on average, during December and January, after remaining around 4-1/2 percent from late 2006 through most of 2007. The higher level of weekly claims for unemployment insurance suggests continued softness in employment this month.

Agreed, the economy has hit the ‘soft spot’ previously forecast by the Fed and private economists.

Apart from the labor market, the hard data on economic activity in the first quarter are limited, but, on the whole, the data suggest economic activity has remained very sluggish. Retail sales were up moderately in nominal terms in January, but after adjusting for the rise in prices of consumer goods, real spending on non-auto goods appears to have been little changed last month. In addition, unit sales of new motor vehicles weakened. Total industrial production rose just 0.1 percent in January for a second consecutive month, and manufacturing output was unchanged. Much of the other information about the current quarter has come in the form of surveys of business and consumers–and most all of it has been downbeat. That said, I can still see a few bright spots. One is that the level of business inventories does not appear worrisome at present. Another is that international trade continued to be a solid source of support for the economy through the end of last year. The worsening financial conditions and slower growth in the United States have had some effect on the rest of the world, but the prospects for foreign growth remain favorable.

Agreed, weak domestic demand supported by rising exports.

The most recent news on inflation–the January report on the consumer price index (CPI)–was disappointing. Once again, total or headline CPI was boosted by a jump in energy prices and relatively large increases in food prices; last month’s rise left the twelve-month change in the overall CPI at 4.3 percent–twice the pace a year ago. In addition, the January increase of 0.3 percent in the CPI excluding food and energy was slightly higher than the average monthly rate in 2007. Nonetheless, the twelve-month change in this measure of core inflation, at 2-1/2 percent, was still slightly below the rate one year earlier. The recent readings on core inflation suggest that the higher costs of energy, a pickup in prices of imported goods, and, perhaps, the persistent upward price pressures in commodity markets may be passing through a bit to core consumer prices.

Headline passing through to core – not good.

The Implications of Financial Stress for the Economic Outlook

(SNIP)

The pressures from the financial turmoil have been most intense for those financial intermediaries that have been exposed to losses on mortgages and other credits that are repricing, as well as for those institutions now required to bring onto their balance sheets loans that previously would have been sold into securities markets. As those intermediaries take steps to protect themselves from further losses and conserve capital, and as investors more broadly have responded to the evolving risks, spreads on household and business debt in securities markets have widened, the availability of bank credit has decreased, and equity prices have weakened.

In addition to the drying up of large portions of mortgage finance that I referred to previously, conditions have firmed on loans for a variety of other purposes. Responses to our Senior Loan Officer Opinion Survey in January showed that banks have tightened terms and standards for household and commercial mortgages, commercial and industrial loans, and consumer loans.

The Fed puts a lot of weight on this and reads it differently than I do. Yes, they have tightened standards, but that doesn’t mean those who had previously qualified no longer qualified under the new standards. For example, requiring a larger down payment is considered tightening, and there’s no evidence yet that would be borrowers don’t simply put more money down. Same with other ‘tightening standards’ issues.

In corporate bond markets, spreads have been widening on both investment- and speculative-grade issues. Lenders are demanding much higher risk premiums for commercial real estate loans. And equity prices have fallen substantially over the past seven months, reducing household wealth and increasing the cost of raising equity capital for businesses.

All true, but part of the great repricing of risk. Arguably spreads were unsustainably narrow a year ago.

To be sure, the easing of monetary policy that I will be discussing in a minute has, quite deliberately, been intended to offset the effect of this tightening, resulting in some borrowers seeing lower interest rates. But financing costs have risen, on balance, for riskier credits, and almost all borrowers are dealing with more cautious lenders who have adopted more stringent standards. Those financial market developments are, in many respects, a healthy correction to previous excesses.

Yes, agreed with that.

But, in some cases, they may represent an overreaction, or at least positioning for the small probability of very adverse economic conditions. In any case, they have the potential to adversely affect household and business spending.

Yes, they have that potential. And regulatory over reach is also a problem he doesn’t address, as the OCC is unnecessarily making things more difficult for small banks to function ‘normally’.

The recovery in financial markets is likely to be a prolonged process. The length of the recuperation will depend importantly on the course of the economy, particularly on developments in the housing market. If the deterioration in the housing market were greater than expected in coming months, the losses borne by financial institutions would be even greater, and lenders might further reduce credit availability. More widespread macroeconomic weakness could make lenders more cautious and could cause the financial problems to spread further. The recent problems of financial guarantors, with possible implications for municipal bond markets as well as for bank balance sheets, are an indication that the financial sector remains vulnerable.

Agreed that parts of the financial sector remains vulnerable, while others are doing exceptionally well.

Even in a more favorable economic environment, some time is likely to be required to restore the functioning and liquidity of a number of markets.

(SNIP)

The Monetary Policy Response

(SNIP)

As the deterioration in financial markets increasingly has threatened to hold down spending and employment, the FOMC has eased monetary policy, reducing the federal funds rate target by 2-1/4 percentage points since the turmoil erupted in August. Those actions have been intended to counteract the effects on the overall economy of tighter terms and conditions in credit markets, the drop in equity and housing wealth, and the steep decline in housing activity. Our objective has been to promote sustainable growth and maximum employment over time.

(SNIPS BELOW)

What policy can do is attempt to limit the fallout on the economy from this adjustment.

Lower interest rates should support aggregate demand over time, even in the face of widespread contraction in the supply of credit.


Among other things, lower rates should facilitate the refinancing of mortgage loans, and they will hold down the cost of capital to business.

Easier policy should also support asset prices–or at least cushion declines that otherwise would have occurred.

And expected policy easing likely contributed to the drop in the foreign exchange value of the dollar, which is bolstering our exports.

Yes, the ‘inflate your way out of debt’ approach. Highly unusual for a central bank to aggressively do this. Harks back to the ‘beggar thy neighbor’ policies of the 1930s.

The extent of the financial adjustment, as I mentioned previously, is itself highly dependent on how housing and the economy evolve. Part of the rise in risk spreads, reduction in credit availability, and the declines in stock prices in the past few months reflect investor efforts to protect themselves against the potential for very adverse economic outcomes–that is, the exposures and losses that would accompany a persistent steep decline in house prices and a significant recession. Of course, these actions–reducing exposures, tightening credit standards, demanding extra compensation for taking risk–themselves make these “tail risk” scenarios even more likely. In circumstances like these, the decisions of policymakers must take account of not only the most likely course of the economy, but also the possibility of very unfavorable developments.

Not including inflation?

Doing so should reduce the odds on an especially adverse outcome not only by having policy a little easier than otherwise, but also by reassuring lenders and spenders that the central bank recognizes such a possibility in its policy deliberations. Whether the Federal Reserve has done enough in this regard is a question this policymaker will be weighing carefully over coming months.

Even as we respond to forces currently weighing on real activity, we must also set policy to resist any tendency for inflation to increase on a sustained basis. Allowing elevated rates of inflation to become entrenched in inflation expectations would be costly to reverse, constrain our ability to cushion further downward shocks to spending, and result over time in lower and less stable economic expansion. Inflation expectations generally have appeared reasonably well anchored, giving the FOMC room to focus on supporting economic growth. Moreover, as I will explain below, for a variety of reasons, I do not expect the recent elevated inflation rates to persist. In my view, the adverse dynamics of the financial markets and the economy have presented the greater threat to economic welfare in the United States. But the recent information on prices underlines the need to continue to monitor the inflation situation very carefully.

The Outlook for Economic Activity and Inflation

How long the adjustment in financial markets will take and the consequences of that adjustment for economic activity are subject to considerable uncertainty. In my view, the most likely scenario is one in which the economy experiences a period of sluggish growth in demand and production in the near term that is accompanied by some further increase in joblessness.

New building activity will continue to decline until the overhang of inventories of unsold homes has been substantially reduced, and the demand side of the market is not likely to revive appreciably until buyers sense that price declines are abating and financing conditions for mortgages are improving. Consumer spending will be damped by the effects on real incomes of a weak labor market and rising energy prices and by the effects of declines in the stock market and home prices on household wealth. Business spending on capital equipment should be held down by slower sales and production and by caution in a very uncertain economic environment. Nonresidential construction is likely to lose some momentum in the wake of both weak growth in overall economic activity and tighter credit. Some modest offset to these areas of weakness should come from export demand, which should be boosted by the lagged effects of recent declines in the dollar and supported by still-solid growth abroad.

Seems he doesn’t realize export demand is part of the cause of higher prices, as non-residents compete with residents to buy the US output of goods and services. That’s what an export economy looks like, and this will continue for as long as non-resident desires to accumulate $US financial assets continues to fall.

By midyear, economic activity should begin to benefit from several factors. One is the fiscal stimulus package that the Congress recently enacted. The rebates that households are scheduled to begin to receive in May should provide a temporary boost to consumption. Although the timing and the magnitude of the spending response is uncertain, economic studies of the previous experience suggest that a noticeable proportion of households are quite sensitive to temporary cash flow. The potential effects of the business incentives are perhaps more uncertain. Although economic theory suggests that they should bring forward some capital spending, past experience has been mixed.

Second, the decline in residential investment should begin to abate later this year as the overhang of unsold homes is worked off, reducing what has been a significant drag on economic growth over the past two years. Finally, the declines in interest rates that began last summer should be supporting activity over coming quarters, and their effects should show through more clearly to improvements in economic activity as the stress in financial markets dissipates.

Although a firming in the growth of economic activity after midyear now appears the most likely scenario, the outlook is subject to a number of important risks. Further substantial declines in house prices could cut more deeply into household wealth and intensify the problems in mortgage markets and for those intermediaries holding mortgage loans. Financial markets could remain quite fragile, delaying the restoration of more normal credit flows. As observed in the minutes of its most recent meeting, the FOMC has expressed a broad concern about the possibility of adverse interactions among weaker economic activity, stress in financial markets, and credit constraints.

I expect the run-up in headline inflation to be reversed and core inflation to edge lower over the next few years. This projection assumes that energy and other commodity prices will level out, as suggested by the futures markets.

No other reasons? Not much to bet the ranch on? And futures prices for non perishables are not about expectations, but about inventory conditions. Contango indicates a surplus of desired spot inventories and backwardation a shortage of desired spot inventories.

The current backwardated term structure of oil and other futures is indicating shortages, which, if anything, tell me the risk is more to the upside than the downside, as well as support my position that the Saudis/Russians are acting as swing producers and setting price.

Moreover, greater slack in the economy should reduce pressure on prices and wages.

Maybe, but also a risky stance.

Rising import prices are in fact rising real wages for US, as many imports have high labor contents.

And given rising import prices of labor intensive goods and services due to the weak $, lower US domestic real wages shift production back to domestic firms, who support US nominal wages and keep employment firmer than otherwise.

Despite high resource utilization over the past couple of years and periods of elevated headline inflation, labor cost increases have remained quite moderate, and inflation expectations remain reasonably well anchored.

As above, rising import prices represent rising labor costs, and inflation expectations have dropped to only ‘reasonably’ well anchored.

Nonetheless, policymakers must remain very attentive to the outlook for inflation. As I mentioned earlier, the recent uptick in core inflation may reflect some spillover of the higher costs of food, energy, and imports into core prices.

To the mainstream economists, this is a serious development.

And the prices of crude oil and other commodities have moved up further in recent weeks. A related concern is that inflation expectations might drift higher if the current rapid rates of headline inflation persist for longer than anticipated or if the recent easing in monetary policy is misinterpreted as reflecting less resolve among Committee members to maintain low and stable inflation over the medium run. Persistent elevated inflation would undermine the performance of the economy over time.

Worse, to a mainstream economist, including Governor Kohn, it’s a necessary condition for optimal growth and employment.

Conclusion

These have been difficult times for the U.S. economy. The correction of excesses in sectors of the economy and financial markets has spilled over more broadly. Growth has slowed, and unemployment has increased; both borrowers and lenders are facing problems, and the functioning of the financial markets has been disrupted. At the same time, inflation has risen.

Yes, weakness and higher prices.

I believe we will see a return to stronger growth, lower unemployment, lower inflation and improved flows in financial markets, but it probably will take a little while.

This ‘belief’ is at best scantily supported in this speech. Lower inflation because futures are lower? Lower employment/output gap and bringing inflation down to comfort zone at the same time?

And adverse risks to this most likely scenario abound: Uncertainty could trigger an even greater withdrawal from risk-taking by households, businesses, and investors, resulting in more pronounced and prolonged economic weakness; events beyond our borders could continue to put upward pressure on inflation rates.

Yes.

But we should not lose sight of some fundamental strengths of our economy. Our markets have proven to be flexible and resilient, able to absorb shocks, and quick to adapt to changing circumstances. Those markets reward entrepreneurship and risk-taking, and many people are looking for opportunities to buy distressed assets and restructure and strengthen businesses to take advantage of the economic rebound that will occur. Monetary policy has proven itself, under a wide variety of circumstances, very effective in recent decades in damping inflation when needed

Yes, but only by hiking rates. There is no other policy option for bringing down inflation.

and in stimulating demand and activity when that has been appropriate. Our job at the Federal Reserve is to put in place those policies that will promote both price stability and growth over time. We have the tools.

They have one tool – setting the interbank interest rates and other rates as desired.

They have no way of directly increasing or decreasing aggregate demand. That requires direct buying or selling of actual goods and services, not just financial assets.

Treasury spending/taxing directly add/removes demand.

As Chairman Bernanke often emphasizes: We will do what is needed.

Yes, to the best of their knowledge and ability.

This is a relatively neutral speech with more inflation talk than in previous, dovish speeches.

Conclusion:
High February CPI numbers before the next meeting will make it very difficult for the FOMC to vote on a cut without a more than anticipated decline of economic activity.

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PBOC to stick to ‘tight’ stance

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PBOC to stick to ‘tight’ stance
Goldman Sachs raises China’s 2008 inflation forecast to 6.8%

To the extent ‘actual inflation’ (whatever that actually is- I realize the difficulties in that statement) is higher ‘actual real growth’ (same qualifications) is lower.

Might partially explain high sustained rates of ‘real’ growth?

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Now versus the 1970s

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Looks very much like the 1970’s to me.

Yes, the labor situation was different then – strong unions due to strong businesses with imperfect competition, umbrella pricing power and the like.

But it was my take then that inflation was due to energy prices, and not wage pressures. Inflation went up with oil leading throughout the 1970’s and the rate of inflation came down only when oil broke in the early 1980’s, due to a sufficiently large supply response. It was cost push all the way, and even the -2% growth of 1980 didn’t do the trick. Nor did 20%+ interest rates. Inflation came down only after Saudi Arabia, acting then as now as swing producer, watched its output fall to levels where it couldn’t cut production any more without capping wells, and was forced to hit bids in the crude spot market. Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades, and inflation followed oil down. And when demand for Saudi production recovered a few years ago they quickly re-assumed the role of swing producer and quietly began moving prices higher even as they denied and continue to deny they are acting as ‘price setter’ with inflation again following.

And both then and now everything is ultimately ‘made out of food and energy’ and hikes in those costs work through to everything else over time.

There are differences between then and now. A new contributor to inflation this time around are our own pension funds, who have been allocating funds to a passive commodity strategies as an ‘asset class.’ This both drives up costs and inflation directly, and adds to aggregate demand (also previously discussed at length).

Also different is that today we’ve outsourced a lot of the labor content of our gdp, so I suggest looking to import prices of high labor content goods and services as a proxy for real wages. And even prices from China, for example, have gone from falling to rising, indicating an inflation bias that corresponds to the wage increases of the 70’s.

Costs of production have been going up as indicated anecdotally by corporate data and by indicators such as the PPI and its components. These costs at first may have resulted in some margin compression, but recent earnings releases seem to confirm pricing power is back and costs are pushing up final prices, even as the US GDP growth slows.

US policies (discussed in previous posts) have contributed to a reduced desire for non residents to accumulate $US financial assets. This plays out via market forces with a $US weak enough to entice foreigners to buy US goods and services, as evidenced by double digit growth in US exports and a falling trade gap. This ‘external demand’ is providing the incremental demand that helps support US gdp, and corporate margins via rapidly rising export prices.

World demand is high enough today to support $100 crude, and push US cpi towards 5%, even with US GDP running near zero.
As long as this persists the cost push price pressures will continue.

Meanwhile, markets are pricing continued ff rate cuts as they assume the Fed will continue to put inflation on the back burner until the economy turns. While this is not a precise parallel with the 1970’s, the era’s were somewhat similar, with Chairman Miller ultimately considered too soft on inflation during economic weakness. He was replaced by Chairman Volcker who immediately hiked rates to attack the inflation issue, even as GDP went negative.

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Another Yellen speech

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Prospects for the U.S. Economy in 2008

(intro remarks snipped)

Today I’d like to talk about developments in the economy and in monetary policy, two items that have definitely been making the news lately. On January 22, the Federal Open Market Committee cut its main policy rate—the federal funds rate—by three-quarters of a percentage point. Then, on January 30, at the scheduled meeting, the Committee voted to cut the policy rate again, this time by half a percentage point to 3 percent. Taking these actions together with those that began last September, the Committee has cut that rate by a total of 2¼ percentage points.

The purpose of these actions is to stimulate demand in the face of the combined impact of the severe contraction in housing and the related financial market disruptions.

The purpose has gone from restoring market functioning to stimulating demand.

While housing construction has been weak for more than two years, its effects did not spill over to most other sectors until fairly recently. That’s why we used to talk about a “dual economy,” with housing notably weak, but other sectors doing well. However, financial markets became disrupted in the middle of last year, which has not only intensified the housing slump, but also has tightened credit conditions for some households and businesses. The combined impact has led to slowing more broadly through the economy. It is this broader slowdown that has elicited Federal Reserve actions in recent months.

Now attention is turned to increasing demand to a fight a slowdown.

(SNIP)

Financial markets

I’d like to begin with a discussion of the disruptions in U.S. and global financial markets, because they influence not only the economy’s most likely course but also the risks that could alter that course. In my view, these disruptions are likely to continue for some time. In other words, I think they have laid bare some fundamental issues with the structure of the financial system that will require significant adjustments.

The financial disruptions are centered in the markets for asset-backed securities.

(SNIP DESCRIPTION OF ABS, RATINGS AGENCIES HISTORY, RISKS)

The bottom line is that, in recent years, the financial system has gone through a significant restructuring that made evaluating and pricing risk difficult. The reverberations of the resulting financial disruption are still with us. I’d like to describe some of them now.

However, the potential stimulatory effects of this drop in risk-free Treasury rates have been offset in many cases by another key feature of the financial turmoil, namely, a sharp rise in interest rate risk spreads, as riskier borrowers have had to pay higher premiums to compensate lenders for a perceived increase in the probability of default or losses in that event. On the corporate side, prime borrowers have actually experienced some net decline in interest rates since the shock first hit—that is, even though risk spreads are higher, they have been more than offset by lower Treasury rates. However, issuers of low-grade corporate bonds with greater credit risk, in contrast, face notably higher interest rates.

Risk has been repriced, and low grade borrowers are still paying more, even after Fed cuts.

The mortgage market has been the epicenter of the shock, and, not surprisingly, greater aversion to risk has been particularly apparent there, with spreads above Treasuries increasing for mortgages of all types. Although borrowing rates for low-risk conforming mortgages are now lower than they were before the financial shock hit, fixed rates on jumbo mortgages are higher on net. Subprime mortgages remain difficult to get at any rate. Moreover, many markets for securitized assets, especially non-agency mortgage-backed securities, continue to experience severe illiquidity; in other words, the markets are not functioning efficiently, or may not be functioning much at all.

She does not think markets are functioning efficiently.

The turmoil is reverberating in depository institutions as well.1 One problem is an unanticipated buildup of mortgages as well as LBO-related loans on their balance sheets.

(SNIP LBO DESCRIPTION)

Furthermore, as investors have pulled back from the markets for asset-backed securities, the value of these securities and CDOs has fallen dramatically, so banks and other financial institutions have had to write down their values, which has shrunk their capital and driven their stock prices down.


Another problem for bank balance sheets is that credit losses have been edging up.

The latest reverberation involves monoline financial guarantors.

(SNIP DESCRIPTION)

Fortunately, the banking system entered this difficult period in a strong position. Most institutions were extremely well capitalized. However, the combination of unanticipated growth in assets and in write-downs has put increased pressure on banks’ capital positions. Given their concerns about capital adequacy and their increased caution in managing liquidity, it is not surprising that they are tightening credit terms and restricting availability. At first, the focus was mostly on mortgages, but now it has spread to other kinds of loans, including home equity lines of credit, credit cards, and other consumer credit, as well as business loans. The tightening of credit is also a response to a now noticeable deterioration in credit quality, particularly for subprime mortgages; the losses in other parts of the consumer loan portfolio remain at relatively low levels from an historical perspective, but they, too, have edged up.

Worries here about the supply side of credit.

Finally, equity markets have hardly been immune to recent financial turbulence. Broad U.S. equity indices have been very volatile, and, on the whole, have declined since August, representing a restraint on spending. More recently, some of these declines have occurred as profits have come in below market expectations for some financial firms due to write-downs of the value of mortgage-backed securities.

My overall assessment is that the turbulence in financial markets is due to some fundamental problems that are not likely to be resolved quickly. The effects of these problems have now made credit conditions tighter throughout most of the economy’s private sector, and this will restrain spending going forward.

That is the actual risk – will spending be credit constrained going forward, and, if so, whether exports and/or government (deficit) spending will pick up the slack and support growth and employment.

The impact hit economic activity mainly in the fourth quarter, and so far, it has been starkly negative. After robust performance in the second and third quarters of last year, growth slowed significantly in the fourth quarter—to a pace of only ½ percent.

Subject to revision. They said much the same about Q3 until it was revised up sharply. And Q4 reported inventory draw-downs of 1.4%; so, demand wasn’t that bad. And it is not unusual for GDP to puring a relatively low number after a very strong quarter like Q3 of 4.9%

This brings me to the outlook for the economy.

Economic outlook

Current indicators point to continued anemic growth for at least the first half of this year as well as significant downside risks even to those weak expectations. As I mentioned at the outset, though the prolonged slump in housing construction did not spill over significantly to the rest of the economy during 2006 and much of 2007, when combined with the recent financial market turmoil, it has been central to the emergence of today’s slow-growth environment. And the course of its resolution will be a key factor in the economic outlook.

The main indicators are the payroll number and the ISM, which are both subject to revision/reversal in a few weeks, and the December trade numbers out later this week that may alter Q4 GDP forecasts.

Not to mention that the current environment has sufficient demand to generate inflation numbers above her comfort zone.

Forward-looking indicators of housing activity strongly suggest that the downward cycle may be with us a while longer.

Agreed, but may have bottomed and not be subtracting materially from GDP going forward.

Despite the subprime and jumbo mortgage challenges, home prices were largely stable in the Bay Area during the first three quarters of 2007. It remains to be seen, of course, how they will do as further market adjustments occur.

On the national level, housing construction probably will continue to contract through the end of this year.

That’s doubtful, but possible.

It is true that the residential construction sector is a fairly small piece of the overall economy and is unlikely to cause significant overall weakness in and of itself.

Right.

But the fallout from the housing cycle has many dimensions, and in the fourth quarter there were signs of spillovers to other sectors of the economy, most worrisomely, to consumer spending. This sector is a huge part of the economy—about 70 percent—and its growth slowed to a rate that is somewhat below its long-run trend in the face of spillovers from the housing market and rising energy and food prices.

A minor slowdown for one quarter, maybe, so far. And the question remains whether exports and government deficit spending will pick up the slack.

Looking ahead, developments related to housing are likely to continue to put a strain on consumers. For example, house prices have fallen noticeably and the declines have intensified. Moreover, futures markets for house prices indicate further—and even larger—declines in a number of metropolitan areas this year.

Future prices? Pretty think market to direct policy.

With house prices falling, homeowners’ total wealth is declining, and that could lead to a pullback in spending.

Maybe, but the Fed economists have no evidence of that.

At the same time, the fall in house prices may constrain consumer spending by lowering the value of mortgage equity; less equity reduces the quantity of funds available for credit-constrained consumers to borrow through home equity loans or to withdraw through refinancing.

Same, no evidence of that yet.

Indeed, it would not be surprising to see even more moderation over the next year or so, as consumers face additional constraints due to the declines in the stock market, the tightening of lending terms at depository institutions, and the lagged effects of previous increases in energy prices.

Spending is predominately a function of income, which has held up so far.

National surveys show that consumer confidence has plummeted. And I have been hearing comments and stories from my business contacts in the retail industry that are also downbeat. The rise in delinquency rates across the spectrum of consumer loans is strongly indicative of the growing strains on households.

Finally, another negative factor for consumption is that labor markets have softened. In recent months, growth in employment from a survey of business establishments slowed sharply, actually falling in January, and many other indicators point in the same direction. Slower job growth will have a negative impact on the disposable income available to households and therefore will provide an additional restraint on consumer spending.

If January is revised up, does the Fed change its tune? They said the same about December employment when it was reported as being low, and then a month later when it was revised to a decent positive number there was no comment. Same when August reported negative then revised to a respectable number a month later.

With the domestic consumer likely to be pretty hobbled, it is tempting to look at consumers beyond our own borders to be a source of strength for economic activity. Foreign real GDP has advanced robustly over the past three years. With the dollar falling well below its level of a year ago, U.S. exports have done very well; partly for this reason, U.S. net exports—exports minus imports—which consistently held growth down from 2000 to 2005, actually gave it a lift over the past couple of years. I expect net exports to remain a source of strength. But some countries—especially in Europe—are experiencing direct negative impacts from the ongoing turmoil in financial markets. Others are likely to suffer indirect impacts from any slowdown in the U.S. A slowdown here could well produce ripple effects lowering growth there through trade linkages, and recently this factor has been reinforced by a worldwide drop in stock prices.

Yes, exports could fall. But they are being driven by an attempt to exit $US financial assets and that means spending them here rather than accumulating them there.

The US has taken strong measures to keep foreigners from accumulating $US financial assets – calling CB’s currency manipulators if they add to their $US reserves, the Fed’s actions making it clear it doesn’t care about inflation, and geopolitical policy driving unfriendly oil producers from accumulating their savings in $US.

This could easily increase US exports and asset sales by $500 billion per year from current levels.

Economic policies are another important factor in gauging the economic outlook. As I have noted, the FOMC has eased the stance of monetary policy substantially in the past five months. Moreover, Congress has now passed a fiscal stimulus package to help the economy and it could provide notable stimulus in the latter half of this year.

Yes, good sized demand add there.

Even with such policy stimulus, the overall economy is still likely to turn in a very sluggish performance this year, expanding by a rate well below potential and creating more slack in labor markets. At 4.9 percent, the unemployment rate is already slightly above my estimate of its sustainable level.

Slightly? That confirms that even the most dovish Fed president thinks about 4.75% is the minimum non-inflationary unemployment rate.

Slow growth this year would most likely push unemployment even higher.

How high does it have to go to keep inflation from rising? To then bring it down to her comfort zone? She would have to say a lot, based on the apparent insensitivity of inflation to unemployment in recent years.

To sum it up, for the next few quarters, I see economic activity as weighed down by the housing slump and the negative factors now impacting consumer spending. It remains particularly vulnerable to the continuing turmoil in financial markets. My comments haven’t even touched on possible slowdowns in business investment in equipment and software and buildings. I see the growth risks as skewed to the downside for the near term.

Right, and agreed, demand has been weakening since Q2 2006 when the budget deficit became too small to support a strong enough credit expansion for full-employment. But exports picked up the slack when the subprime home buyers were the first to fall by the wayside.

In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop—that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold.

The countercyclical tax structure limits this. Just like th early 1990s when the slowdown drove the budget deficit to 5% of GDP (equal to about a $750 billion deficit today) and added that much net financial equity to trigger and support the boom of the second half of the 1990s.

With a gold standard, this does not happen. The government run that kind of deficit without losing reserves and defaulting. Like the US did in 1934 when it went off the gold standard.

Now let me turn to inflation. The recent news has been disappointing. Over the past three months, the personal consumption expenditures price index excluding food and energy, or the core PCE price index—one of the key measures included in the FOMC’s quarterly forecasts—has increased by 2.7 percent, bringing the increase over the past twelve months to 2.2 percent. This rate is somewhat above what I consider to be price stability.

Yes, even as demand is slowing.

I expect core inflation to moderate over the next few years, edging down to around 1¾ percent under appropriate monetary policy.

What does that mean? She said the Fed has been cutting rates to add to demand. How does adding to demand bring down inflation?

Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. Moreover, I believe the risks on the upside and downside are roughly balanced. First, it appears that core inflation has been pushed up somewhat by the pass-through of higher energy and food prices and by the drop in the dollar. However, recently, energy prices have turned down in response to concerns that a slowdown in the U.S. will weaken economic growth around the world, and thereby lower the demand for energy.

Hardly! Oil is still trending higher, as it bounced off of $86 got through $94 yesterday. And January 2008 gasoline consumption was 1.4% over January 2007 – during the ‘slowdown’ emphasized above. Not to mention grain prices and the CRB in general. And anecdotal earnings reports showing trending cost push inflation taking hold both internationally and domestically.

Another factor that could restrain inflationary pressures is the slowdown in the U.S. economy.

Hasn’t yet. In fact, seems to be getting worse if anything.

This can be expected to create more slack in labor and goods markets, a development that typically has been associated with reduced inflation in the past.

Not in the 1970s. Not with ‘imported’ cost push inflation, and now with biofuels liking food to fuel and with a couple of billion up-and-coming consumers in India and China competing for resources.

And not to mention our own pension funds increasing their allocations to passive commodity strategies – pure, inflationary hoarding.

A key factor for inflation going forward is inflation expectations. These appear to have become well-anchored over the past decade or so as the Fed’s inflation resolve has gained credibility. Very recently, far-dated inflation compensation—a measure derived from various Treasury yields—has risen, but it’s not clear whether this rise is due to higher inflation expectations or to changes in the liquidity of those Treasury instruments or inflation risk. Going forward, we will need to monitor inflation expectations carefully to ensure that they do indeed remain well anchored.

Right, as if monitoring will keep them anchored.

Actions now speak louder than words. The Fed’s actions are telling us loud and clear that at least so far they have been willing to step hard on what the believe is the inflation pedal to soften a slowdown, with unemployment still very near what they consider full-employment.

The question is: how sever does inflation have to get for the Fed to address it with action rather than ‘monitoring’?

Monetary policy

Now let me turn to monetary policy. The federal funds rate has been cut by 2¼ percentage points since September and now stands at 3 percent. With near-term expected inflation of just above 2 percent, the real—inflation adjusted—funds rate is around 1 percent or slightly lower, which represents an accommodative posture.

OK, they do consider the current FF rate accommodative.

And as core creeps up, the Fed sees it as more accommodative.

I believe that accommodation is appropriate because the financial shock and the housing cycle have significantly restrained economic growth.

But not inflation, at least not yet.

While growth seems likely to be sluggish this year, the Fed’s policy actions should help to promote a pickup in growth over time. I consider it most probable that the U.S. economy will experience slow growth, and not outright recession, in coming quarters. At the same time, core consumer inflation seems likely to decline gradually to somewhat below 2 percent over the next couple of years, a level that is consistent with price stability.

Why is it likely to decline? Don’t see any support for what that position apart from it used to decline when unemployment went up. But even then, it took a lot more unemployment to decline the way they are expecting it to.

However, economic prospects are unusually uncertain. And downside risks to economic growth remain.

And that means a downside risk to inflation as they must be assuming inflation is a function of growth? If so, why not say it?

This implies that, going forward, the Committee must carefully monitor and assess the effects of ongoing financial and economic developments on the outlook and be prepared to act in a timely manner to address developments that alter the forecast or the risks to it.

My guess is the Fed’s forecast has not been revised down since the last meeting, but the inflation forecast may be revised up and appropriate monetary policy might be implying higher rates down the road.

I expect she would vote for a rate cut at the next meeting if conditions remain the same, if she was still a voting member.

Now, I’d be glad to take your questions.

Endnotes

In recent months, and particularly toward year-end, strains were evident in the term interbank funding markets; in these markets, banks borrow from and lend to each other, with loans maturing in a number of weeks, months, or even a year. The problem has been that banks that would normally lend their excess funds to other banks that need them became reluctant to do so. This may reflect banks’ recognition of the need to preserve liquidity to meet unexpected credit demands, greater uncertainty about the creditworthiness of counterparties and concerns relating to capital positions, on top of typical, year-end balance sheet considerations. A heightened focus on liquidity is logical when the markets for securitized assets held by banks have become highly illiquid and when the potential exists for some customers—such as struggling mortgage companies and others—to draw on unsecured credit lines. These markets have improved since the end of last year, perhaps in part because of the Fed’s introduction of the Term Auction Facility, which gives banks another route besides the discount window to tap into the Fed’s lending function. (Banks had not used the discount window very much despite their need for liquidity because they were concerned that doing so might erroneously signal to other financial institutions that they were in bad straits. The plan for the TFA, which the Fed created in cooperation with the European Central Bank and the National Bank of Switzerland, was announced on December 12.)

♥

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Responses to comments on the ‘Comments on Brian Wesbury article’ post

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Post: Comments on Brian Wesbury article

Comment by ‘Hoover Printing Press‘:

Warren congrats on your new website.

Thanks!

I keep reading that the bond insurers have let banks keep lots of “accounting issues” off the books – thus affecting tier 1 capital requirements – currently to the banks advantage. Without the bond insurers and their AAA rating by moody and sp (fitch has already lowered ratings down from AAA) the banks will have to scramble for lots of capital without the insurance, barclays recent estimate upwards of 150 billion. I remember Buffet referring to Financial WMD’s.

Yes, but that’s a matter of institutional structure. The government has several options.

For example:

  • The government could change bank ‘haircuts’ to capital by allowing AA insured bonds to have the same or only marginally higher capital charges as AAA bonds. The capital requirements are somewhat arbitrary to being with and meant to serve public purpose.
  • The government could offer some for of supplemental insurance at a fee to investors holding the AAA insured bonds in question. Again, for example, the fee could perhaps be 1%, and the government could guarantee a price of 97 to any investor who paid the fee. The government will probably make a profit on this type of program, as the monolines’ capital will still be in first lost position, and even if they are downgraded to AA, the implication is they will have more than sufficient capital to cover all losses. That is what AA means.

I read articles that NY is in a mad scramble to get buffet and others to bring some assurances to the bond insurance industry because the muni debt market is going to seize up without bond insurance and what the AAA ratings of that insurance lends to capital requirements and “accounting issues.”

Yes. There are some institutional ‘land mines’ in place that the government can either prevent from being tripped or defuse directly (for a fee), as above.

In hoover’s time I remember reading from Rothbard’s great depression I believe that he printed but the banks used the money to shore up their reserves, they did not want to lend and spur the economy at the cost of their own survival.

Under that gold standard regime, the government was limited in what it could do. Deficit spending carried the risk of loss of gold reserves, for example. And, in fact, the US was forced off the gold standard in 1934 domestically and devalued for foreign holders of $. This was the only actual default in US history.

So why is Bush and congress giving joe six pack 150B when he could have used that to back the bond insurers and the banks?

No comment.. You must be new here??? :)

Possibly getting the ratings agency to save some face and for fitch to bring AAA ratings back to the bond insurers?

Or the supplemental plan, above, that doesn’t bail out the insurers.

On another point, you claim a large difference between hoover’s problems and our problems today is the gold standard and floating exchange rates. Unfortunately I must press you as to how that is so when the folks at the top of this chart (china) http://en.wikipedia.org/wiki/List_of_countries_by_current_account_balance have fixed exchange rates relating to the folks at the bottome of it (USA). Soros is claiming the USA will soon lose reserve currency status.

A fixed exchange rate ‘forces’ you to run a trade surplus to sustain sufficient reserves of gold or the reserve currency of choice. It also limits the ability to conduct countercyclical deficit spending as that leads to loss of reserves and default/devaluation/etc.

China has a ‘dirty float’, which means the currency is not convertible, but instead they intervene at various prices.

Not at all the same thing.

I am not so sure the Euro will be able to weather a global financial meltdown and perhaps in economic warfare, keeping reserve currency status is worth fighting over.

What is it, and why do you care?

With bush selling lots of scatter bombs to the house of Saud, at least we are trying to keep friends who have control over oil.

Still with the USA’s current account balance the worst of any country on the planet,

Imports are real benefits, exports real costs. In general, the larger your trade deficit, the higher your standard of living.

40K nukular bombs and a war machine that eats up large domestic resources, and a consumer base whose only skill is to shop till princess drops,

Consumption is the only point of economics.

I am not so sure what you are trying to save to get USA to deficit spend even MORE?

Right now, more deficit spending of the type proposed will mainly increase inflation.

Would it be so bad if that guy “dfense” from the mike douglas movie “FALLING DOWN” gets put out of a missle building job and starts fishing on the dock of the bay wasting time?

Comment by Scott Fullwiler:

Wesbury’s basically a monetarist (everything that goes wrong is the Fed’s fault for creating either too much or too little “liquidity”) operating with a gold standard model.

Yes, that’s where we don’t agree on causation and risks. But interesting that even in that paradigm, he doesn’t see the risks the Fed does, as they are in the same gold standard paradigm.

That said, he’s been bullish on the economy since 2002, and he’s been mostly right in that, except that he’s also been saying inflation is right around the corner since then, too, given weak dollar, strong gold.

And I’ve seen inflation underway due to Saudis acting as the swing producer and hiking price continuously.

And I see the weak $ as a change in preferences of non-resident holdings of financial assets.

Until a year and a half ago he was also claiming that the large spread b/n st and lt Treasuries was another a sign of inflation,

And I say it’s a sign of what investors think the Fed will be doing next. So to that extent, the curve reflects investor expectations. But there is also a lot of institutional structure that steers maturity preferences; so, the result is a mix of the two.

though he decided bond markets were being irrational once the yield curve inverted (again, if inflation is right around the corner).

Again, that reflects investor expectations.

I’ve used him in my classes for several years as a “balance” to the Levy view of “debt deflation’s around the corner.” Interesting to see that you and he are on the same page now at least regarding state of the economy, since you’ve been pessimistic (at least in long run, given small govt deficit) while he’s been a non-stop bull.

Yes, I’ve been expecting lower domestic demand since the financial obligations ratio go to where it go in Q2 2006, due to the shrinking budget deficit. What I missed was how strong exports would be, mainly on our three pronged weak dollar policy that has been scaring foreigners away from holding $US financial assets.

This includes calling CB’s currency manipulators if they buy $US, aggressive Middle Eastern policy, and the Fed’s apparent lack of concern for the value of the currency (inflation). Fundamentally, the falling budget deficit is good for the $US, but technically government policy has triggered an ‘inventory liquidation’ over seas that is causing exports to boom.

And now we are learning the hard way (or should be) what an export driven economy looks like – weak domestic demand due to high prices and full employment as we build goods and services for others.

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Fed cuts increasing demand and lowering the dollar support crude prices

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Oil futures jump back above $90 a barrel

by John Wilen

Oil futures jumped back above $90 a barrel Friday, adding to the previous session’s sharp gains on a view that the recession worries that pulled prices lower in recent weeks may have been overblown.

So markets are now linking rising oil prices to a stronger economy? This is a change in rhetoric from the previous talk that high oil prices were slowing demand, to the current talk that high demand is driving up oil prices.

This would signal to the Fed that markets are saying the economy is now strong enough to cause further inflation.

Energy investors were heartened by recent moves by the Federal Reserve and Congress to shore up the economy, which could prevent oil demand from slowing as much as many had feared.

The Fed doesn’t want this to happen – markets seeing their moves as supportive of higher inflation.

“This week’s emergency interest rate cut by the Fed and the economic stimulus plan proffered by Congress appear to have, for now, stemmed fears of a looming recession in the U.S.,” said Addison Armstrong, director of exchange traded markets at TFS Energy Futures LLC, of Stamford, Conn., in a research note.

Word that Chinese oil demand grew by 6.4 percent in December, the highest rate in months, contributed to oil’s advance.

Concerns that demand from the booming Chinese and Indian economies is outstripping global oil supplies helped push oil to records above $100 earlier this month.

Rising oil prices are also signaling that India and China continue to grow quickly enough to drive up prices.

Light, sweet crude for March delivery rose $1.30 to settle at $90.71 on the New York Mercantile Exchange after rising as high as $91.38. Oil futures last closed above $90 last Friday.

While investors believe the government’s $150 billion stimulus plan and the Fed’s rate cuts will stave off a serious economic slowdown, rate cuts also tend to weaken the dollar, giving investors another reason to buy oil futures. Crude futures offer a hedge against a falling dollar, and oil futures bought and sold in dollars are more attractive to foreign investors when the greenback is falling.

And the Fed’s cuts have weakened the dollar and also contributed to the higher oil prices.

In other words, the article is stating that the rate cuts caused both strong demand and a weak dollar, both driving up inflation.

The financial media is beginning to look past recession fears and to inflation.

Look for article about how the Fed is falling behind the inflation curve.

“When (investors in foreign) countries go to buy oil, they’re buying it on sale,” said James Cordier, president of Liberty Trading Corp., in Tampa, Fla.

Many analysts believe the weakening dollar helped draw speculative investors into oil markets this fall and winter, driving oil prices
above the $100 mark.

Other energy futures also rose Friday. February heating oil futures jumped 4.28 cents to settle at $2.5191 a gallon on the Nymex while February gasoline futures added 3.54 cents to settle at $2.3182 a gallon. Heating oil and gasoline prices were supported by news that Valero Energy Corp.’s 255,000 barrel a day refinery in Aruba was shut down due to a fire.

February natural gas futures rose 18.1 cents to settle at $7.983 per 1,000 cubic feet.

In London, March Brent crude rose $1.83 to settle at $90.90 a barrel Friday on the ICE Futures exchange.

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Re: UN Warns of Biofuels’ Environmental Risk

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(an email)

THANKS, DAVID, COMMENTS BELOW IN CAPS

>    Subject: UN Warns of Biofuels’ Environmental Risk
>
>
>   By MICHAEL CASEY
>   AP Environmental Writer
>   BANGKOK, Thailand
>
>   The world’s rush to embrace biofuels is causing a spike in the price of corn
>   and other crops

THE REASON THE PRICE IS GOING UP IS THAT HUNGRY PEOPLE ARE COMPETING
FOR WHAT’S LEFT TO EAT AFTER THE ACREAGE GOES TO FUEL PRODUCTION

and could worsen water shortages and force poor communities off
>   their land, a U.N. official said Wednesday.

FORCING PEOPLE OFF THE LAND IS SECONDARY TO FOOD AND WATER SHORTAGES?

>   Foremost among the concerns is increased competition for agricultural land,
>   which Suzuki warned has already caused a rise in corn prices in the United
>   States and Mexico and could lead to food shortages in developing countries.
>
>   She also said China and India could face worsening water shortages because
>   biofuels require large amounts of water, while forests in Indonesia and
>   Malaysia could face threats from the expansion of palm oil plantations.

also:

The New York Times
Governments in Europe and elsewhere have begun rolling back generous,
across-the-board subsidies for biofuels, acknowledging that the
environmental benefits of these fuels have often been overstated.

SEEMS THAT THE POTENTIAL TO STARVE TENS OF MILLIONS OF PEOPLE TO DEATH
TAKES SECOND PLACE TO ENVIRONMENTAL CONCERNS.

UNTIL THAT HAPPENS, GOVTS WILL PROBABLY CONTINUE THE CURRENT LEVEL OF
SUPPORT AND KEEP FOOD PRICES LINKED TO FUEL,

THIS IS PROBLEMATIC FOR THE FED AS CPI WILL KEEP RISING WITH GASOLINE
PRICES, WHICH WILL DRAG FOOD ALONG WITH IT. AND BOTH OF THESE FEED
INTO THE COST SIDE AND PUSH UP CORE MEASURES AS WELL.

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2008-01-24 China Highlights

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Highlights:

China growth reaches 13-year high

Still importing heaps, including capital goods.

China’s 11.2% Fourth-Quarter GDP Gain Props Up Global Growth as U.S. Slows
China’s consumer price index rises 4.8 pct in 2007

Inflation is ripping, meaning higher prices for the rest of the world.

Yuan Rises to Highest Since Link to Dollar; Fitch Calls for Faster Gains

Meaning higher prices for US consumers.

Fixed asset investment up 24.8%, industiral output up 18.5%
China’s industrial output up 18.5% last year

Not too shabby.

Articles:

China growth reaches 13-year high

Building and infrastructure projects are fuelling economic growth.

The Chinese economy has expanded by 11.4% over the past year, reaching its fastest growth rate in 13 years, officials have announced.

Increased exports and a boom in the construction industry helped the rapid expansion during 2007.

But officials warned that overheating remained a danger, despite a slight slow-down in the fourth quarter.

Inflation is also a serious concern, with many Chinese people hit by recent dramatic increases in food prices.

‘Still developing’
Announcing the figures, National Statistics Bureau chief Xie Fuzhan said Beijing was paying “close attention” to the US credit crisis.

He said Beijing would respond by making “timely and proper adjustments” in exchange and interest rate policy, but gave no details.

Speculation has been mounting among analysts over whether China has overtaken Germany to become the world’s third-largest economy.

But Mr Xie played down the comparison, saying: “It’s not really important to know whether China is the fourth-largest or the third-largest.

“Even if the total surpasses Germany, China is still a developing country – in particular, the per capita GDP of China is really low.”

China’s 11.2% Fourth-Quarter GDP Gain Props Up Global Growth as U.S. Slows

(Bloomberg) China’s economy expanded more than 11 percent for the fourth straight quarter, supporting global growth as a recession looms in the U.S. Gross domestic product rose 11.2 percent in the three months ended Dec. 31, compared with 11.5 percent in the third quarter, the statistics bureau said in Beijing today.

Industiral output up 18.5%
Industrial output jumped by 18.5 percent last year, 1.9 percentage points higher over a year earlier.

The industrial output at companies with annual revenue of at least five million yuan (US$691,600) expanded by 17.4 percent in December, compared with 17.3 percent in November.

The output growth rates were 13.8 percent for the state-owned enterprises and those in which the state holds controlling stakes and 17.5 percent for companies invested by foreign, Hong Kong, Macao and Taiwan businessmen, Xie said.

The companies sold 98.1 percent of the goods they produced last year.

Industrial output growth decelerated from September onward, as the government’s tightening measures took effect. The year-on-year growth figures for September and October were 18.9 percent and 17.9 percent, respectively.

Output growth rates were 13.8 percent for state-owned enterprises and organizations in which the state holds controlling stakes and 17.5 percent for foreign-, Hong Kong-, Macao- and Taiwan-invested businesses, Xie told press conference in Beijing.

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Fed’s Fisher

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Doesn’t get any more hawkish than this.

Well worth a quick read.

Richard W. Fisher
Challenges for Monetary Policy in a Globalized Economy
Remarks before the Global Interdependence Center
Philadelphia, Pennsylvania
January 17, 2008

Thank you, Charlie [Plosser]. I am grateful for the invitation to speak to the Global Interdependence Center.

(NON ECON INTRO SNIPPED)

You’d be hard pressed to find an economist or market operator in this city or anywhere else on the planet who is not concerned about waning U.S. economic growth. Some analysts and commentators sound like Chicken Littles. Others are less excitable, but are nevertheless assuming a defensive crouch. Most are mindful of recent developments in employment patterns, uneven retail sales and downward shifts in shipping, rail and trucking indexes, industrial activity, business capex plans, credit card payables, purchasing manager activity and other carefully watched indicators. These stresses follow on the severe housing downturn and the liquidity bind. There is an increasingly insistent drumbeat urging the Fed not only to not impose contractionary policy on a weakening economy, but indeed to get “ahead of the curve” through further monetary accommodation.

Chairman Bernanke spoke last week and made it clear that the FOMC stands “ready to take substantive action needed to support growth and provide insurance against downside risks,” adding that “additional policy easing may well be necessary.” In short, he made clear that the FOMC does not intend to just squat and wait should economic data and sound risk management signal that monetary accommodation is required.

It needs to be underscored that being proactive and not passive in doing our job does not mean that we will abandon prudent decisionmaking. We are the central bank of the United States, the bellwether economy of the world. Our job is not to bail out imprudent decisionmakers or errant bankers, nor is it to directly support the stock market or to somehow make whole those money managers, financial engineers and real estate speculators who got it wrong. And it most definitely is not to err on the side of Wall Street at the expense of Main Street.

In fact, to benefit Main Street, we have a duty to maintain a financial system that enables American capitalism to do its magic. To this end, we have recently taken steps designed to circumvent
bottlenecks in interbank lending—steps that include changing the operation of our discount window and opening a new term auction facility. This facility has provided $70 billion in funds in roughly a
month and will soon provide another $30 billion, and perhaps even more over time if needed.

In setting broader monetary policy and the fed funds target rate, the Fed operates under a dual mandate. We are charged by Congress with creating the monetary conditions for sustainable, noninflationary employment growth. Put more simply, our mandate is to grow employment and to contain inflation. Unstable prices are incompatible with sustainable job growth. Some critics worry that we have forgotten that axiom. We haven’t.

Let me give you my personal view.

In discharging our dual mandate, we must be mindful that short-term fixes often lead to long-term problems. The Fed occupies a unique place in the pantheon of government institutions. It was deliberately designed to be calm and steady, untainted by the passion of the moment and immune to political exigency and influence. Because monetary policy’s effects spread into the economy slowly and accumulate over time, having an itchy trigger finger with monetary policy risks shooting everyone in the foot. Our policy mandate must be discharged with careful and deliberate aim.

In the attention-deficit world of television and Internet commentary, where so-called “instant analysis”—an oxymoron if there ever was one—makes headlines, it is easy to understand why one might think that the effect of a change in the fed funds rate would immediately alter the dynamic of the economy. To be sure, movement in the fed funds rate, or even no movement at all, may have an immediate psychological effect and influence expectations for future monetary policy action. But the act of changing or not changing the fed funds target rate, in and of itself, has no immediate effect on the economy. Like a good single malt whiskey, the ameliorating or stimulating influence kicks in only with a lag.

The lag time necessary for inflation to respond to policy is especially long. As a policymaker discharging our dual mandate, I am always mindful that in providing the monetary conditions for employment growth, we must not also sow the seeds of inflation that will eventually choke off the very employment growth we seek to encourage. You do not have to be an inflation “hawk” to recognize that would be a Faustian bargain.

Those of you who follow my speeches—probably a very small number of you with way too much time on your hands—will recall that I like neither the term “hawk” nor “dove.” I like to think that all FOMC
members are best metaphorically described in ornithological terms as “owls”—wise women and men seeking to achieve the right balance in carrying out our dual mandate. To be owlish, and to avoid the
imbalance of emphasis that gave rise to needed harsh discipline imposed by the Volcker FOMC, one has to bear in mind that the seeds of inflation, once planted, can lie fallow for some time, then suddenly burst through the economic topsoil like kudzu, requiring a near-toxic dose of countermeasures to overcome.

In the pre-Volcker era, the Fed had a less-than-admirable record of keeping inflation at bay. But over the past few decades, we have done well enough to both contain inflation and engender growth that far outpaced other advanced economies for a sustained period with only a smattering of short recessions. In short, the Fed has delivered on its mandate.

To be sure, we have been profoundly impacted by the shifting economic dynamics that have complicated our efforts to continue delivering on our mandate. I need not try to convince members and supporters of the Global Interdependence Center that we are living in a globalized world. Increasingly, globalization is blurring economic boundaries. On the inflation front, for example, we have extensive economic playbooks that tell us how to treat the wage–price spiral or cost-push forces in a closed economy. In a closed environment, one would ordinarily expect that a weakening economy would lead, in turn, to a diminution in price pressures. But we have less experience with prescribing policy in an open economy where demand-pull forces come from beyond our borders—such as the burgeoning demand for commodities and food from rapidly growing and newly consequential economies like China, India, Latin America and the countries liberated from the oppression of Soviet communism. These faraway places play an ever-increasing role in determining prices here at home.

Writing in last Sunday’s New York Times, Ben Stein noted this and that the Fed does not have much power to influence the price of oil.[1] He is right. And for that matter, we can’t do much about the external demand impacting the price of food—which, by the way, carries twice the weight of energy in the consumer basket of personal consumption expenditures. But the dynamics of production and demand among the new participants in the global economy nonetheless impact us in different ways at different times. As these new participants joined the global economy, they provided significant tailwinds, helping us grow by providing cost savings, new sources of productivity enhancement and new sources of demand, helping fatten both the top line and bottom line of our businesses while also holding down inflation. Under such conditions, the Fed could operate with a more accommodative monetary policy than what might have been appropriate in a closed economy, without putting upward pressure on inflation. And that is what the Fed did, although some argue—with the benefit of hindsight—it did so for too long.

I think it is now clear that the winds have shifted. The growing appetite for raw inputs from the new participants in the global economy represents an inflationary headwind that is unlikely to soon abate. The so-called “income elasticity of demand” for energy is 1.2 across a wide range of countries, which is a fancy way of saying that economic theory should lead one to conclude that the demand for energy in, say, China, for example, would begin to grow faster than China’s income growth, which continues to increase at a rapid rate. Put more simply, income growth in China and India and elsewhere, even if it slows from its torrid pace, is likely to continue raising demand for food and energy. There is a risk that upward price pressures will continue to affect American producers and consumers of energy and food products and a continuing danger that overall inflation expectations will drift upward as a result.

If I am correct, then the situation today is the flip side of the 1990s and early 2000s: In delivering on our mandate to be monetary policy “owls,” we will have to err on the side of running tighter policy than would otherwise be justified if we wish to limit upward inflation pressures.

I mentioned single malt whiskey earlier to describe the effective time lags of monetary policy. I realize it is only lunchtime, but let’s return to the economics liquor cabinet for a moment. Inflation is like absinthe. The narcotic allure of inflation is a dangerous thing. It might seem like the remedy to bail out a government or a bad book of business and forget your troubles. Yet our experience in the past has taught us only too well that inflation is a dangerous elixir that ultimately proves debilitating for businesses, consumers, investors—including those foreign investors who have lately come to the aid of some large balance sheets here—and especially for the poor, the elderly and people on fixed incomes. It even inculcates bad financial behavioral patterns in the young by encouraging spending rather than investment and saving. Inflation is bad for Main Street and Wall Street and even for Sesame Street.

Yet we central bankers also traverse Lombard Street, and we know from Walter Bagehot that in times of crisis, liquidity is key. As a voter on the FOMC this year, I stand ready to take substantive action to support growth and provide insurance against downside risk, as long as inflation expectations remain contained.

You will note the operative qualifying words there were “as long as inflation expectations remain contained.” Each of us looks to different indicators for a sense of inflation’s direction. Some peruse markets for signs of shifting expectations, looking, say, to the yield on Treasury Inflation-Protected Securities, or TIPS, or to the spread between yields in the forward markets between TIPS and nominal Treasuries at different points of the yield curve or all along the entire curve. Personally, as a former market operator, I am wary of relying on Treasury spot or futures indicators during a flight to quality or at times when liquidity is at a premium, as investors may have other preoccupations that trump or distort conventional inflation concerns.

Others look to surveys of consumers and professional forecasters, like those conducted by the University of Michigan and the Philadelphia Fed. The latest, the University of Michigan survey, released in December, is forecasting headline Consumer Price Index (CPI) inflation of 3.4 percent, which is hardly comforting. The Philadelphia Fed survey, released last November, provides a more palatable forecast of 2.4 percent for the next four quarters; yet if you plot that survey against actual headline inflation obtained for the last four years, it has more often than not underestimated inflation’s true path.

The brow of a central banker considering further accommodation furrows further when looking at the inflation measures that form the basis for Main Street’s inflationary expectations—the CPI and the Personal Consumption Expenditures (PCE) deflator. On a 12-month basis, the most recent CPI, released yesterday, was running at a rate of 4.1 percent. The last PCE deflator, released in December, was 3.6 percent. The Trimmed Mean PCE Deflator, which the Dallas Fed tracks in an effort to eliminate “noise from signal” and as a basis for projecting inflation, is no longer trending downward. Even the so-called “Core PCE,” which I personally consider least useful because it eliminates food and energy prices, is rising rather than declining.

Of course, what matters most is the future direction of inflation, not the past. In the course of preparing for each FOMC meeting, I regularly consult directly with some 30-plus CEOs to develop a sense of future business activity, including cost and pricing developments. I have found this rigorous exercise to be extremely helpful in placing our staff’s econometric analysis in context as I have prepared for FOMC meetings in the past, and I will be listening especially carefully to these business operators’ reports on inflation-related developments as I prepare for upcoming FOMC meetings.

In my view, the degree of substantive action to support economic growth and insure against downside risk will be conditioned by what we see coming down the inflation pike. To deliver on its dual mandate, the Fed must keep one ear cocked toward signs that inflationary expectations are drifting upward as we execute additional monetary measures.

Let me bring this home to Philadelphia. In 1748, Benjamin Franklin wrote an “Advice to a Young Tradesman.” In it, he speaks in the language of the day of the concepts of opportunity cost and of the power of compound interest—pretty precocious stuff for those times. Of the money supply, he wrote that “the more there is of it, the more it produces [at] every turning, so that the profits rise quicker and quicker.” Yet he also warns in earthy terms of the dangers of being too prolific. “He that kills a breeding sow,” Franklin warned, “destroys all her offspring to the thousandth generation. He that murders a crown [the currency of the day], destroys all that it might have produced….”

The late Dame Mary Douglas was no Ben Franklin. Nor was she a Philadelphian. She was a brilliant British economic anthropologist who wrote a pathbreaking book titled Purity and Danger. In it, she wrote something that Franklin or Stephen Girard or any good central banker since the onset of time has understood implicitly: “Money can only perform its role of intensifying economic interaction if the public has faith in it. If that faith is shaken, the currency is useless.”

Like Charlie and my other colleagues, I have every desire to use monetary policy to intensify economic interaction, to keep breeding jobs and growing our economy, so that we might keep America strong to the thousandth generation. I have no intention of being party to any action that might shake faith in the dollar. The challenge to monetary policy, as I see it, is to achieve the growth part of our mandate in the short term and get “ahead of the curve” without shaking faith in the currency over the long term.

I know that the GIC has other things on its mind than just monetary policy. So let me stop there and answer any questions you might have.

About the Author

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas.

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