Manna From Fed Heaven

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from a Hearing of the House Financial Services Committee, February
15, 2007

The Federal
Reserve figuratively prints the thing we all want more of. Why so
little of this manna seems to find its way into deserving pockets
is at the top of today's agenda.

Under the law,
the Fed has a dual mandate. It must protect against inflation, as
defined, and promote full employment. But Congress and the American
people have come to expect much more from our central bank than
even that tall order. We ask, in addition, that it make an inherently
risky world safe. We expect the Fed to deliver us from the consequences
of hedge-fund explosions, sovereign-debt defaults, bear stock markets,
bank failures, deflations and other financial and economic vicissitudes.
It can't be done. Goldman Sachs itself would blanch at the task.
It's not that low inflation and high levels of employment are incompatible.
They are not, I believe. The experience of the past 50 years assigns
a pretty heavy burden of proof to any exponent of the so-called
Phillips curve in any of its many guises. A little more inflation
may bring forth (for a while) a little more employment. Much more
dependably, a little inflation will deliver a little more inflation,
and then a little more, and so forth, followed by much less employment.

The trouble
with the Fed's mandate boils down to two obstinate facts. The first
concerns inflation itself. It is not easy to define, let alone to
control. "Too much money chasing too few goods" is familiar
but incomplete. "Too much money, period," is better, though
admittedly vague. What the money chases varies from era to era.
In the 1970s, it was goods and services. More recently, it was houses
(and office buildings and highly leveraged corporations, among other
investment assets). The fact that we called this levitation of house
prices something besides inflation does not alter the fact that
a monetary disturbance changed the way millions of Americans lived
and worked. Once upon a time, former chairman Alan Greenspan defined
inflation as a change in prices sufficient to cause people to adjust
their behavior. The house price bubble exactly conforms to that
definition. It was a kind of inflation.

Obstinate fact
No. 2 lies in the way the Fed goes about its work. It fixes an interest
rate. This one and only policy instrument is a very blunt tool.
What Pope Julius II did not say to Michelangelo was, "Here's
your roller. Now go paint the ceiling of the Sistine Chapel."
It is worse than that with the Fed, however, because a paint roller
never destroyed an industry or led directly to shortages of New
York City apartments or disintermediated the nation's thrift institutions.
So great is the Federal Reserve's prestige that it is easy to gloss
over the essentially disreputable method by which it goes about
its job. The fact is that the Fed — like the unreformed Texas Railroad
Commission, the New York City rent-stabilization apparatus and the
late, unlamented Interstate Commerce Commission and Civil Aeronautics
Board — is in the business of price control.

Now I want
to give credit where credit is due. The currency that the Fed sponsors
is passed from hand to hand the world over. It is not the first
dominant global monetary brand — the pound sterling ruled the roost
in the 19th century and for a few decades of the 20th.
But the dollar is the first universally honored irredeemable paper
currency. Not since 1971 has anything tangible stood behind it.
It is uncollateralized — faith-based — yet the world accepts it.
It is America's greatest export. The United States consumes much
more than it produces and discharges its foreign debts in money
that it alone is allowed to print. If there were ever a golden age
of paper money, this is it.

Perhaps out
of respect for these wonderful facts, the financial world has suspended
its disbelief about the Fed's operating method. Ask a Wall Street
economist if the Department of Agriculture should set soybean prices
or the Federal Energy Regulatory Commission gasoline prices, or
whether the Fed itself should get back into the business of fixing
bank deposit rates (as it did from 1933 to 1980), and your answer
would be a disdainful stare. Yet these same believers in the efficacy
of price discovery accept that the Fed can determine the correct
federal funds rate. They go further: Having dreamt up the right
rate, the Fed should impose it on the market.

Of course,
people in markets are not infallible. Neither are people in bureaucracies
incapable. Markets are not divinely ordered. But market judgments,
however imperfect, are generally less imperfect than the decisions
decreed from on high. It's true that the Fed does not impose its
will without reference to markets. But, having taken the markets'
pulse, the Fed sometimes decides that it knows better than they
do. It so judged in 2002–03, and it seems to believe it again
today. This is very thin ice on which the Fed is skating — on which
we are all skating, the American wage earner not least.

The Fed was
at its most unilaterally willful four years ago. You may recall
that the Federal Open Market Committee was agitated about what it
chose to call deflation. The stock market bubble had burst, there
was a short recession (March-November 2001), the CPI had lost its
bounce and employment growth was disappointingly sluggish. Japan
had not yet rubbed the sleep out of its eyes from a decade-long
economic hibernation. The risk of falling prices preoccupied our
central bank.

The Fed had
begun to chop away at its interest rate before the recession officially
began. It was hard at it all during 2001. By the time the anti-deflation
campaign reached full rhetorical strength, the funds rate sat at
1 percent, the lowest in decades. But it was still too high, the
FOMC broadly hinted. Messrs. Bernanke and Greenspan vowed to do
everything in their power to hold the inflation rate to a decent
minimum, say 1 percent to 2 percent a year. And to what lengths
would they go? "[T]he U.S. government has a technology called
a printing press (or, today, its electronic equivalent)," said
Mr. Bernanke in November 2002, "that allows it to produce as
many U.S. dollars as it wishes at essentially no cost." That
left little enough to the imagination. Neither did the remarks of
his then boss, Mr. Greenspan, who observed: "The Federal Reserve
has authority to purchase Treasury securities of any maturity and
indeed already purchases such securities as part of its procedures
to keep the overnight rate at its desired level. This authority
could be used to lower interest rates at longer maturities. Such
actions have precedent: Between
1942 and 1951, the Federal Reserve put a ceiling on longer-term
Treasury yields at 2%."

To some of
us, these urgent warnings seemed misplaced. They were inconsistent
not only with earlier Fed pronouncements, but also with common sense.
In the late 1990s, the Fed could hardly stop talking about free
trade and high productivity growth. They were unqualified blessings,
it said. Digital technology was a time-and-motion man's dream come
true. The fall of communism and the rise of the Internet were opening
previously shut-in labor markets in Asia and the former Soviet Union.
The global supply curve was shifting downward and to the right.

The sum of
these changes pointed strongly to everyday low, and lower, prices
for tradable goods and services. Was this not a good thing? Not
exactly, the Fed now decided. Once the inflation rate approached
the zero mark, it might keep falling. And if prices actually fell,
and kept falling, why would anyone go shopping today? They would
wait for the sales tomorrow. And it must have weighed on Messrs.
Greenspan and Bernanke that the U.S. economy was increasingly leveraged.
Falling prices are good for consumers, bad for debtors. The United
States itself had become a sizable debtor to the rest of the world.

Wall Street
did not dwell overly long on the possible inconsistencies of the
Fed's anti-deflation policy. It focused instead on moneymaking.
If Mr. Greenspan, a lifetime apostle of free markets, was now threatening
to muscle 10-year yields down to as low as 2 percent, it was an
open invitation to buy bonds. Market interest rates, including mortgage
rates, duly plunged.

Interest rates
are the traffic signals of a market economy. Green, red or amber,
they direct the speed and destination of investment capital. The
solid green signals of the early 2000s channeled capital and labor
into residential real estate. The influx transformed the character
of the mortgage market. No more, it seemed, did home buyers have
to apply for a loan. More and more, the lenders came to them, whoever
they were. Newfangled mortgages — "affordability products,"
as they were called — threw open the doors of home ownership to
millions of formerly unqualified buyers.

The Fed's low
interest rates and the lenders' ingenuity combined to bridge the
gap between high house prices and not-always-high incomes. If a
simple adjustable-rate mortgage could not close the deal, the bankers
and brokers had other ideas. Option ARMs, deferred-interest loans
and easily accessible junior liens meant that just about nobody
couldn't qualify. White lies, too, played their part in the drive
toward universal home ownership. So-called low-documentation mortgages
put the applicant on his or her honor. Income? Job title? Years
of employment? Your word was your bond. Low-doc mortgages became
especially popular among subprime buyers. In 1999, according to
UBS mortgage research, just 21 percent of low-rated loans were closed
with less than full documentation. In the past two years, fully
41 percent were. Wall Street gathered up these millions of new mortgages,
packaged the collateral and modeled the cash flows to create asset-backed
securities. The scale of this operation is one of the wonders of
modern finance. Of all the residential mortgages outstanding in
the United States, 80 percent were originated after 2002. Of all
the subprime mortgages outstanding, 75 percent were originated after

Without this
interest-rate-assisted mortgage boom (and credit-assisted consumption
boom), job growth in the early 2000s might have been even more sluggish.

As it was,
according to Asha Bangalore, an economist at Northern Trust Co.,
housing-related employment generated 43 percent of all private-sector
job creation from November 2001 to April 2005. As might be expected,
this kind of work has been getting scarcer. Thus, from November
2001 to January 2007, housing-related businesses have produced just
19 percent of all private-sector jobs. The famously adaptable U.S.
economy is generating new opportunities.

is a very handy quality these days, as the financial traffic lights
are sometimes stuck on red or green, a source of confusion and the
occasional financial pileup. Now is one of those difficult times.
The Fed's interest rate, 5 percent, is the highest on the Treasury
yield curve. The market seems to want a lower structure of interest
rates, whereas the FOMC is prepared to push higher. The market appears
to be less worried about inflation than about the unintended consequences
of the mortgage bubble — i.e., rising delinquencies and foreclosures,
a nasty downturn in the prices of some of the mortgage-backed securities
created last year and the risk of contagion in the wider economy.
The Fed, for now, will have none of it. It is worried about inflation
but sanguine on the economy and the housing situation alike.

companies must disclose the side effects of the pills and medications
they advertise, and the purveyors of monetary remedies should be
held to a similar standard of candor. Once, at least, the FOMC seemed
to own up to some of the unwholesome consequences of its radical
intervention of 2001–04. "Some participants," said
the minutes of the Dec. 14, 2004, FOMC meeting, "believed that
the prolonged period of policy accommodation has generated a significant
degree of liquidity that might be contributing to signs of potentially
excessive risk-taking in financial markets evidenced by quite narrow
credit spreads, a pickup in initial public offerings, an upturn
in mergers-and-acquisition activity and anecdotal reports that speculative
demands were becoming apparent in the markets for single-family
homes and condominiums."

These concerns
were well-founded, and two years later the "signs of potentially
excessive risk-taking" are even more glaring. The subprime
mortgage market, about which we are suddenly hearing so much, has
its counterpart in the business world. Speculative-grade corporations
are borrowing heavily at concessionary interest rates and with ever
less documentation. They, like the subprime mortgage borrowers of
2005 and 2006, seem to expect low rates to persist or — at the very
least — that the capital markets will afford them some future opportunity
to refinance their debts on terms just as advantageous as the ones
they have recently secured. On the other hand, millions of subprime
borrowers are discovering that sometimes interest rates go up, and
asset prices go down.

The Fed owes
its public a forthright accounting of the risks it runs with the
policy it pursues. I mean the risk that it picks the wrong interest
rate, one that sets in motion a train of adverse events unimagined
by the people who imposed the rate in the first place. In all things
economic and financial, the Fed is a force for what it likes to
call stability. But few things are so ultimately destabilizing as
a belief that the world is in for a long spell of peace and quiet.

Fed, like a good physician, should first do no harm. And, like a
good drug company, it should not withhold its warnings on side effects.
In interest rates as in painkillers, the secondary reactions can
be debilitating.

19, 2007

Grant, author of Minding Mr. Money, The
Trouble With Prosperity
, and biographies of Bernard Baruch and
John Adams, is editor of Grant’s
Interest Rate Observer

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