:: Has the Fed Painted Itself in a Corner?

ozymandius (1000+ posts)

Mon Jun-09-08 11:55 AM Response to Original message

17. Has the Fed Painted Itself in a Corner?

Without a doubt, the Federal Reserve now faces the most difficult financial and economic climate in our collective memory. And it is increasingly apparent that its options are constrained. Although it is premature to arrive at definitive judgments, it's nevertheless worth asking whether some of these limitations were unwittingly self-created. Friday's market rout, triggered by the one-two punch of an unexpectedly large rise in unemployment and an $11 spike in oil prices, put paid to the idea that the Fed might put through a wee interest rate increase before year end. We didn't expect anything more than 25 basis points, since the second leg of the credit crunch, this time dragging down regional and local banks, is underway. And Wall Street has not hit bottom either. But as Wolfgang Munchau tells us in the Financial Times, for the first time in modern memory, a foreign central bank's stance, in this case, the ECB's, is limiting the Fed's scope of action: In the past, European central bankers tended to follow the US Federal Reserve, often with delay, never perfectly, but generally in the same direction.....The policy response to our most recent financial crisis has been different. While the Fed cut by an accumulated 325 basis points, the Europeans first refused to follow, and they are now moving in the opposite direction.... the ECB is now likely to raise interest rates by 25 basis points next month, and I suspect this could be followed by another rate increase later this year.... This suggests that in terms of global monetary policy, we are in the middle of a shift from a unipolar to a bipolar world. In the past, the Fed’s policy alone used to determine the global monetary policy stance – via the dollar, the global anchor currency. Through long periods of loose monetary policies, including lengthy episodes of negative real interest rates, the Fed contributed directly to the rise in global inflation.... ..... As monetary policy of the world’s two largest economies moves in starkly opposite directions, interesting possibilities are opening up. One is whether the dollar will decline prematurely as a global currency – an issue on which economists are divided. Differential inflation rates could plausibly trigger such a shift. As US inflation rises, more and more countries may unpeg from the dollar to avoid imported inflation. If this trend persisted, the US would risk losing its exorbitant privilege – the ability to live beyond its means thanks to a globally domineering currency. Bernanke has treated the dollar with benign neglect, but now that the oil has become a preferred dollar hedge. Even if oil would fall to $110, it would still put brakes on the economy, and oil above $130 or higher will suck any remaining life out of the economy. The high prices haven't yet worked their way through to the pump, and the secondary effects, such as the price effects of higher shipping costs, are only beginning to kick in. But how did the Fed get itself here? There are different ways to frame the problem. We're of the view that the central bank took rates too low and left them low for too long in the dot-bomb era, and cut too deep, too fast this time. Former Fed economist Richard Alford explains that those decisions were the product of a flawed analytical framework.... http://www.nakedcapitalism.com/2008/06/has-fed-painted-...