WSJ: The Fed's Bender

The following appeared on page A18 of the Monday April 28, 2008 issue of the Wall Street Journal.

So Federal Reserve officials are whispering to reporters that they will consider a "pause" after another interest-rate cut this week. Perhaps we should be more respectful, but this sounds like the alcoholic who tells his wife he'll quit drinking next weekend, after one more bender. What Chairman Ben Bernanke needs isn't a gradual withdrawal from easy money but membership in Central Bankers Anonymous.

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Eight months into the Fed's most recent rate-cutting spree, the evidence is overwhelming that it has been a major policy mistake. Aggressive rate cutting - taking the fed funds rate to 2.25% from 5.25% last September - has had little effect on the banking crisis it was supposed to ease.

The recent progress on that front has come principally from the Fed's discount window innovations, especially its lending to investmetn banks in the wake of the Bear Stearns rescue. That is the kind of targeted liquidity that helps the financial system handle fears of bank failure and solvency without risking inflationary side-effects. The shame is that the Fed didn't do more of this earlier, along with tougher regulatory oversight of the likes of Citigroup. The way to save a troubled banking system is to focus on specific problems via dividend cuts, new management, losses in shareholder equity, rights offerings and other new capital, and if need be public money through the Federal Deposit Insurance Corp.

Meanwhile, the Fed's decision to open the general monetary spigots has inspired a global commodity boom unlike any since the 1970s. Oil has climbed to nearly $119 a barrel today from $70 in late August, a 70% increase. Farm and other commodities have seen a similiar surge, with corresponding increases in food prices leading to shortages and riots in Egypt and other places, and to rice hoarding even in Southern California.

The popular media explanation is that this price surge is a result of rising global demand, greedy speculators and human profligacy. All of sudden, without warning, the world is said to be running out of food. After 30 years in intellectual hibernation, Thomas Malthus and the Age of Scarcity are back in style.

No doubt commodity traders are having a field day, but what they are speculating on is the Fed's refusal to stop the free-fall of the dollar. The weak dollar has created another speculative bubble, this time in commodities. Oil prices have been surging despite only the usual geopolitical risks to global supplies and despite a recent International Energy Agency estimate the global oil demand will fall as growth slows.

As for food prices, it's true that government policies supporting biofuels have created new demand for corn and other grains. This and price controls in some countries have contributed to the food panic. But the price surge has been so rapid and so broad across nearly all commodities that it can't merely be a function of supply glitches or new demand for specific grains.

Like oil, world trading in most commodities is deonominated in dollars. When the dollar declines, especially as fast as it has since September, commoditiy prices surge and speculators gamble on even further declines. As the nearby chart shows, since 2003 the dollar price of oil has climbed far more rapidly than has the euro price - 273% in dollars, compared to 146% in euros. Note in particular the oil spike in dollars since the second half of last year. This reflects the European Central Bank's sounder monetary management. And it means that had the dollar merely retained the same purchasing power as the euro, today's price of oil would be below $70 a barrel.

The practical impact has been to send energy and food prices soaring. This is a direct tax on both the world's poor and America's middle class. Just when the U.S. economy needs a resilient consumer given the fall in housing prices, these price increases have eviscerated consumer pocketbooks. In its attempt to help Wall Street and the financial system, Fed policy is punishing average Americans. The public is frustrated and angry with these price increases, and it has a right to be. Inflation is the thief of the thrifty middle class.

The Fed's weak dollar policy ahs also done great harm to overall financial confidence, which is essential to any growth revival. A main source of the credit crisis is a lack of trust. Investors stop taking risks, bankers stop lending, and everyone flees to the safety of Treasurys or cash. But how can the Fed expect people to calm down and begin taking risks when it is clearly debasing the currency? Monetary easing itself also becomes less effective, because without confidence more liquidity is merely "pushing on the string," in the famous phrase.

The Fed's problem has been both political and intellectual. Politically, Mr. Bernanke has been unwilling to say no to Wall Street and the Beltway political class, which reflexively demand easier money in a crisis. This demand has become almost Pavlovian since Wall Street came to believe during the late 1990s in what was known, fairly or not, as the "Greenspan put." It takes character to resist this political pressure, but that is what Fed chairmen are supposed to have.

As for the intellectual problem, the Fed and much of Wall Street convinced themselves that the only inflation measure that matters is "core inflation," which excludes food and energy. The Fed's monks devised that measure to avoid an overreaction to commodity price movements, but instead they have used it to pretend that food and energy prices don't matter. Throughout this decade, they pointed to core infaltion to argue that "inflationary expectations remain well anchored," even as the dollar and commodity price signals were telling us that the opposite was true. Americans don't buy gas and groceries with "core" dollars.

In fairness to the Fed, it has had many allies in dollar-devaluation. The manufacturing lobby promoted it, as ever, to spur exports and profits, while the Bush Administration has acquiesced in the hope that it would reduce the trade deficit. (Oops.) The housing bubble was a societal mania brought on by the Fed's subsidy for credit, and no one wanted it to end. Even many of our supply-side friends dismissed concern about price signals and the falling dollar, focusing too much on the benefits of tax cuts and forgetting the monetary lessons of the 1970s. Some of these sages are finally coming around, but too late to prevent the economic and policy damage.

The ironic and unfortunate cost may be that political blame for rising prices and any recession will fall unfairly on Bush fiscal policy. As we've been writing for several years, the greatest threat to economic growth has been reckless monetary policy. Yet both the Bush Treasury and John McCain's campaign seem oblivious to the monetary roots of our current economic troubles.

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As the Fed's open-market committee meets this week, what the world wants is a revivial of American monetary leadership. It wants the Bernanke Fed to stop the global run on the dollar, and that means declaring an end of its rate-cutting mistake.