Inflation targeting is yet to be formally
adopted by the Federal Reserve, but recent market
and Fed actions already proved that it is a
failure. At the whim of trouble in the markets,
Fed chairman Ben Bernanke has made it clear that
he is inclined to flood the markets with liquidity
at any cost. He said: "We stand ready to take
substantive additional action as needed to support
growth and to provide adequate insurance against
downside risks."
Contrast that with
John-Claude Trichet's comments: the head of the
European Central Bank (ECB) recently said that
during times of financial turmoil, it is
imperative that inflationary expectations remain
firmly anchored. The Fed's increasing isolation is also
apparent from recent comments
by Bank of England governor Mervyn King, who said
investors had been mispricing risk for far too
long and that "the repricing of that risk ... is
not a process that we should try to reverse".
Let me be clear: we have no problem with a
central bank switching into emergency mode per se.
But the way the Fed has wobbled into emergency
mode, claiming to be vigilant on inflation while
debasing the dollar in the process smells of
hypocrisy.
A central bank's role is to
keep the financial system running, not to run the
financial system. Bernanke has very clear views on
how the financial system ought to be running. In
February 2004, when he was freshly sworn in as a
Fed governor, he published a report called "The
Great Moderation". In it, he praised how monetary
policy has contributed to a reduction in
volatility of output and inflation since the mid
1980s. At first sight, it seems difficult to argue
with such analysis; this work may have contributed
to his appointment as President George W Bush's
chief economic advisor and subsequently to his
current role as chairman of the Federal Reserve.
While we do not deny that low volatility
has positive implications, where there is
sunshine, there is shadow: in our assessment, the
seeds of the current crisis have been planted in
the process. Even if you are not an economics PhD,
you may recall the saying: "If there is one thing
the market does not like, it is uncertainty."
The less uncertain the world is, the more
daring speculators become. Homeowners believing
their jobs are secure, or their wages will rise,
are more likely to take out a high mortgage. Any
speculator is willing to take out more leverage
when the future seems certain.
Financial
institutions have become increasingly
"sophisticated" over the past decade and have
introduced widely acclaimed value-at-risk (VaR)
models; these assess the risk of loss given
different scenarios. Put simply, the less
volatility, the less uncertainty there is, the
more capital may be put at risk. In recent days,
there has been talk that banks may require over a
hundred billion dollars in additional capital
should mortgage insurers be downgraded.
That's because the banks' models suggest
that less capital is required for assets
classified as safe; however, if someone spoils the
party and says the world is a risky place, banks
suddenly have a greater portion of their capital
at risk, requiring them either to sell off risky
assets on their balance sheets or to raise more
capital.
This academic-sounding concept
has major implications for a credit-driven world:
every speculator, homeowner, bank, private equity
firm, hedge fund and bank is borrowing more money
in an environment of low volatility. The process
of borrowing increases money supply. Up until a
year ago, this money went into all asset classes,
from stocks to bonds to commodities to real
estate. The alarm bells should have gone off at
the Fed long ago because just about all asset
classes were rising simultaneously.
This
can only happen when a bubble is in the making.
Usually, investors invest in either stocks or
bonds; commodities don't usually move in tandem
with the stock market, but have low correlations.
Rather than being alarmed at the growth of
money supply, the Federal Reserve patted itself on
the back for having reached an era of lower
volatility. In March 2006, the Fed ceased
publishing M3, a broad measure of money supply
because "M3 does not appear to convey any
additional information about economic activity ...
and has not played a role in the monetary policy
process for many years."
We even agree
with the Fed that M3 is an outdated measure of
money supply. But its shortcoming is that it is
too narrow a measure; rather than turning its back
to the study of money supply, the Fed should have
intensified its efforts, trying to understand how
modern financial instruments influence money
supply.
Instead, the Fed is increasingly
focused on inflation. The problem is that
inflation is a lagging indicator. Not only that,
the government has changed the definition of
inflation so many times that it has become rather
meaningless. Incidentally, inflation used to be
monetary inflation, pure and simple; nowadays, it
is whatever variation of the consumer price index
seems appropriate to justify a policy decision.
Take the widely cited focus on "core"
inflation that excludes food and energy. Such
exclusions may have originally been justified:
food and energy prices were notoriously volatile
and may make monetary decision making more
difficult. But when you have food and energy
prices elevated for years, when you burn food to
create energy, that justification no longer
exists, and neglecting it in monetary decision
making is, to put it mildly, inappropriate.
In its efforts to keep volatility in
inflation and output low, the Federal Reserve has
been tempted to sugarcoat structural problems in
the economy. The real world, of course, is not
risk-free, and volatility has come back with a
vengeance. In the process of de-leveraging,
speculators withdraw money from all assets. And
because the US (consumers and the government) has
been the world leader in borrowing, the
traditional safe haven, the US dollar, is also
under pressure.
Rather than allowing
volatility to return to the markets, the Federal
Reserve is fighting market forces, incidentally by
increasing money supply. But the market is more
powerful than the Fed. Also, as the Fed has lost a
lot of credibility in recent months, any policy
action is far more expensive than in the past: the
much-touted increased transparency was aimed at
managing the yield curve (the relationship between
long-term and short-term interest rates) through
words rather than policy actions. Now, the Fed had
to have an intra-meeting rate cut of 0.75% to try
to achieve its objective.
Just as the
pitfalls of the value-at-risk models are haunting
us now, just as the Federal Reserve's attempts to
reduce market volatility are backfiring, the
entire industry focuses too much on "normalcy".
The Fed's models work great during normal times;
during such times, we might argue, we don't need
the Fed. And during times of turbulence, the Fed
is struggling to match expectations set in the
bond futures markets; again, one has to wonder why
we have a Federal Reserve in the first place, if
all it can do is create inflation.
During
the Fed's emergency rate cut, only William Poole,
governor of the Federal Reserve Bank of St Louis,
voted against; while Poole would also be hesitant
to tighten monetary policy merely because of an
increase of money supply without signs of
increased pressure on prices, at least he is
consistent. Not only that, it is good to have a
healthy respect for market forces demanding an
increase in money supply, as there may well be
reasons why an increase in money supply is due to
sustainable increases in economic activity.
In our humble opinion, inflation targeting
should be dead. Monetary policy ought to focus on
money supply, to dampen monetary bubbles as they
develop. And if there are extended "normal"
periods where the Fed's role is to do nothing,
then that’s not a reason to find a new target;
instead, it should stay on the sidelines.
The current thinking at the Fed is that
bubbles must not be prevented from happening, as
it would amount to interfering with asset prices;
with due respect, all monetary policy interferes
with asset prices, and the most recent emergency
rate cut does so more blatantly than orderly
policy would have done.
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