Although investors have been worried about the Fed’s exit strategy for some time, you wouldn’t see much evidence if you looked at the markets. While gold prices are an exception, the stock market appears to reflect optimism about recovery (although cynics would say it really is a function of liquidity, not fundamental views). Either premature tightening or a pickup in inflation would sully this pretty picture.
Thomas Hoenig voiced the concerns of the hawkish camp. The Fed’s traditional method for pegging interest rates is based on an approach called the Taylor rule, devised by economist John Taylor of Stamford. The Financial Times reports that Bernanke, in a speech defending the Fed’s policies, showed that using its own version of the Taylor rule as a guide, rates were too low in 2009.
The Wall Street Journal Economics Blog also describes some papers by Fed staff, one from the St. Louis Fed, the other from the Richmond Fed, both concerned about the possible resumption of inflation. But this strikes me as a peculiar focus, particularly in light of what just happened. Conventional wisdom is that monetary authorities have considerable latitude to resort to stimulative monetary policy as long as inflation remains tame. But we now have an environment, at least in the US, where labor has no bargaining power. Look at the last cycle, where the share of GDP going to corporate profits rose to record levels while worker wages were stagnant. And we had a period where interest rates were well below the level indicated by the Taylor rule for a protracted period. And what did we get? A big credit bubble.
Even though the Fed and other central banks recognize this danger intellectually, they have not internalized it. Indeed, many observers, including your humble blogger, believe that the “throw liquidity at the markets” program was to prop up asset prices (although the authorities rationalize that by telling themselves that they had reached irrationally depressed levels. Funny how they had no problems with irrationality when prices were frothy). So now that they are formally in the bubble reflating game, when can they tell that enough is enough? While they have some notion of what range of inflation is salutary, they have no such view re asset prices (and if they did, it might prove a tad inconvenient, since housing in some markets is still too high relative to rentals and income levels).
At least Hoenig gave a prominent role to the risks to stability:
“Experience both in the US and internationally tells us that maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess, economic volatility and even higher unemployment at some point in the future,” he said. Mr Hoenig rejected Mr Bernanke’s argument that the Fed decision to keep rates low after the dotcom crash did not contribute meaningfully to the housing and credit bubble. “Low interest rates contributed to excesses,” he said.
But Bernanke, in his eagerness not to repeat a Great Depression, is discounting the risk of another set of bubbles leading to an even bigger wipeout.