Tuesday, June 24, 2008

Do-ality duality and dual mandates duel at the Fed

Dueling mandates
Under Bernanke we have come to know (if we did not before) that the Fed has a dual mandate - a responsibility to maintain growth and to contain inflation. It's a little tougher than walking and chewing gum at the same time. With Barney Frank heading the House Financial Services Committee, Bernanke has been reminded of this constantly and we hear a number of Fed speeches remind us of this goal at their start. This has been a NEW development since Greenspan left.

But that goal, that mandate, has always been there. It lies like a snake under a rock and only occasionally slithers out to bite someone. As it is now.

Why oil problems are so slick...
Oil has a dual a nature. Higher prices create some headline inflation (incipient inflation) and at the same time they depress the economy by siphoning off spending power from the consumer. Its the perfect thing to drive the Fed mad. And it is doing so now, cranking headline inflation up and ratcheting growth lower.

This bring us to the Fed's dilemma its do-ality: what's it to do? It is on the spot again this week with an FOMC meeting on tap. Up to this point it has cut rates but more for the banking system's problems. Still, those rate cuts have helped the economy deal with its oil shock. But in the last few weeks the Fed has been making noises that inflation was the bigger risk. It made these noises loudly enough and often enough that the market took them seriously. Rates began to back up and futures prices began to embody the notion of a rate hike and the Fed began to wonder what the market was so worried about.

Wrong bedtime story
So the Fed climbed up into its bully pulpit and began to preach the sermon of anti-inflationism to the faithful who took it to heart. That sermon changed their behavior and that was not what the Fed had wanted. It did not want market rates to go up. It did not want markets pricing in a rate hike. It wanted to reassure us it was on guard. And it was misguided- like a mother wanting to read a soothing tale to a child at bed time, but then choosing to a short story by Edgar Allen Poe. "Oh, here honey we'll read 'The Tell Tale Heart' before bedtime"... maybe not.

Rebate checks: a flash-in-the-pan-acea
So now the Fed has to deal with what it is. It has a dual mandate. Oil's dual nature is stalking the Fed every minute. The Fed's own do-ality has come back to bite it on the bottom and it does not know what to do. One thing is for sure it can't undo what it has done. Some in the markets are afraid of inflation and the Fed has stoked their fears. But palpable risk still challenge the economy. The Rebate checks do not seem to have been much of a panacea- more like a flash-in-the-pan-acea. The Fed is really unsure-as is the market -what's next. The Fed is clear on its destination (no inflation) but not its path to get there.

A leaky pipeline
In putting this fear of of God (actually, fear of of inflation) into the markets the Fed has even undone some of its past stimulus. Bank lending has tightened and taken some more pressure out of the pipeline as sure as a leaky hose robs the nozzle of pressure.

Frankly speaking: Maximum unsustainable farce
For all of its good work on liquidity facilities the Fed has squandered part of it though the old Fed bug-a-boo, bad communication. Partly it gets back to that dual mandate that Barney Frank made the Fed dredge up. Under Volcker and Greenspan we did not have this problem. The Fed went for price stability alone. Why? Because it could. It argued that IF it kept prices stable the economy would grow at its maximum sustainable rate. And it was right. Frank forced the Fed to bring up growth and re-inserted the quandary at the head of the line into a process that had worked so well without it. So you can blame the Fed and Bernanke for this failing but blame Frank too. He has put the Fed in an untenable position.

Unwelcome distraction
When push comes to shove we know what the Fed will do. It will protect against inflation. That is why Bernanke's warning was unneeded. There will always be Fed doubters. Contrarians are a constant. But the Fed must focus on doing what's right. I think Bernanke's heart was in the right place but he still managed to get it wrong. The economy is very weak and the Fed may yet be forced to cut rates before it raises them. The rebates may not have provided as much support as he thought. The Fed's warning that boosted market rates and especially mortgage rates was an unwelcome distraction. Still it's real.