classical economics
for analysis,  forecasting
and policy design

Jumping the Shark at Fed

By Wayne Jett
©  July 16, 2007

    Was July 10, 2007, a watershed event in the 94 years history of the Federal Reserve Board? We know one thing. Fed chairman Ben Bernanke provided greater transparency into the theory and practices of the central bank of the world’s largest economy. Only time will tell whether the event foretells monetary policy reform the institution and the global economy so desperately need.
Managing Domestic Interest Rates
    Since 1971, the Fed for the most part has chosen to manage domestic interest rates while the dollar’s value “floats” as the market adjusts to the manipulated interest rate and other economic conditions. Managing domestic interest rates was endorsed by British economist John Maynard Keynes in 1936 as a means to subsidize domestic producers in competition with foreign manufacturers. Keynes advised such subsidies so a positive trade balance could finance domestic prosperity, thinking a “state of persistent depression” otherwise inevitable. Keynes also distrusted market rates of interest set by bankers as too great a risk to domestic employment.
    Because banks and their customers borrow more when interest rates are below market, artificially low interest rates creates excess currency. This lowers the currency’s unit value, which is inflation.  Those who manage interest rates fight inflation by reversing their field, raising rates to artificially high levels. Doing so penalizes domestic production and increases unemployment. Unfortunately, the higher interest rates weaken economic growth and demand for currency. This actually causes more inflation, especially when the Fed continues to inject new currency liquidity by buying Treasury securities.
    The Fed’s interest rate management practices produce an almost persistently weak dollar. In 1970, $35 would buy an ounce of gold, which now costs $670. Crude oil then cost less than $3 per barrel, but now costs more than $70. Housing, food, transportation, education, entertainment – all prices have soared. Intermittently, in 1980-1982 and 1996-2002, the dollar’s value has leaped, causing prices to drop and debtors to be crushed under heavier debt loads with lower revenues to service them. The deflation that began in 1996 followed nearly ten years of relative stability for the dollar at $350 to $400/oz of gold. In 2003, the dollar steadied at that value, but the Fed’s hikes in rates beginning in June, 2004, slowed economic growth and dropped the dollar’s value as low as $735/oz before the rate “pause” finally came in August, 2006. All the while since 2003, the Fed has injected new liquidity by buying Treasury securities.
Inflation Expectations “As The World Turns”
    In this setting, chairman Bernanke describes inflation, how it occurs, how the Fed gauges and forecasts it, and research needed for the Fed to perform better. The chairman implies inflation is price instability, which he says is “greatly influence[d]” by the “state of inflation expectations,” which in turn appears to be the most important state of the union in the Fed’s view. Expectations are thought processes of individuals and firms as they anticipate future prices. Expectations are “anchored” when “relatively insensitive to incoming data.” Bernanke’s remarks explore at length the importance of inflation expectations and difficulties in assessing how well anchored they are. Then he tells why the degree of anchored-ness is significant in the Fed’s use of the Phillips Curve: since inflation expectations have become better anchored, “inflation will now tend to be more stable than in the past in the face of variations in aggregate demand.” Putting that into plain English, inflation is likely to remain high longer as the Fed raises the funds rate target, so the inflation fight will be harder and rates will have to go higher. Bernanke proceeds to describe aspects of research on anchored-ness of expectations that could assist the Fed in its work, and implores economists to pursue those issues. Presumably the Fed could be depended upon for funding those research efforts.
    Perhaps in a Princetonian setting of purely academic inquiry, such esoteric treatment of the problem at hand might be tolerable, even honorable. Here, however, the issue is monetary inflation, the central concern facing all economies around the globe with the fate of humanity in the balance. To overcome inflation, the Fed focuses on how to assess and manage psychological attitudes of populations towards prices.
The Business of Banking
    For centuries, the business of banking and finance has been viewed as requiring the ultimate in hard-headed, sound judgment, and with good reason. Banking’s objective is financial stability achieved through clear-eyed assessment of risk. It is easy to envision an academic theoretician walking into a boardroom of an international bank, beginning his presentation on well-anchored inflation expectations as the cornerstone of sound currency policy, and being thrown through the door (if not the window) for wasting time on such precocious and poorly “anchored” thinking.
    The banking community is known to have effective and broad-based influence at the Fed, and the Fed chairman undoubtedly portrays accurately the theory and practices used there. The Phillips Curve remains central to the Fed’s work because it traces data relating employment and prices. As the Fed uses the funds rate target to manage domestic interest rates, the Phillips Curve remains relevant because the funds rate intentionally pushes unemployment higher with the objective of reducing wage increases. The Fed turns to discussions of inflation expectations and how well anchored they are, most likely, to avoid discomfort that rises when explaining why marginal workers must by put out of work if inflation is to be minimized.
    With Fed theory and practice being so detached from reality – indeed, so irrational – the question must be asked why presumably hard-headed bankers tolerate this “Fed-speak.” It is certainly not banker talk, at least not since 1987 when Alan Greenspan became chairman. The answer appears to be that Fed-speak serves bankers’ purposes. How might this be?
Why Bankers Tolerate The Federal Reserve
    Keynes proposed government management of domestic interest rates partly to isolate those rates from the “whims of bankers” who set their rates in market competition. The Fed sets the funds rate target with great influence from bankers. The funds rate target then becomes the benchmark by which all banks set their “prime” rate (funds rate plus 3%). The prime rate then becomes the benchmark for rates applicable to other-than-prime borrowers (prime plus 2%, or prime plus 3%). With that interest rate structure in place, competition on the basis of interest rates is minimized if not eliminated from the banking and financial sectors. Participants in many business sectors would jump at the opportunity to set prices if the law permitted them to do so. Thus, it should not shock the conscience to suggest bankers are actually pleased that interest rates are set through the Fed under imprimatur of law.
    But the rest of us should not be pleased. The practice causes inflation, which gives the Fed excuse to raise rates more; inflation and rates rise together until recession, and then investment bankers buy assets at bargain prices. With the interest rate manipulation, workers lose jobs, bargaining power and standard of living. The same economic detriments that flow from protectionist tariffs flow from controlled domestic interest rates because the latter are a form of protectionism. Protectionism is, of course, anti-competitive, as is setting interest rates. Not surprisingly, consumers suffer from the lack of competition.
    Legend is that the long-running television comedy “Happy Days” finally reached the point beyond which it could not proceed when the scriptwriting became so absurd the ultra-cool Fifties character “Fonzie” Fonzarelli (played by Henry Winkler) went water-skiing, black leather jacket and all, and had to jump over a shark while skiing and maintaining his all-important cool. The phrase “jump the shark” was born to encapsulate an event so absurd it signals the gig has been extended beyond reasonable limits, and it’s over. May it come to pass that the chairman’s tale of anchored inflation expectations on July 10, 2007, is such an event in the history of U. S. monetary policy. ~