Monday, March 26, 2007

Critiquing the Federal Reserve

With hindsight it is easy to critique the interest rate policies of the Federal Reserve. If they had raised rates earlier in the 1990's there may not have been quite so much of a shock from the bursting of the Internet bubble. If they had not sent rates so ridiculously low in 2002 to 2004 then we would not be suffering now from all the turmoil in the housing market. Some folk even think the nation would have not suffered through the Great Depression if the Federal Reserve had been on the ball, both to dampen enthusiasm in the late 1920's and to flood the country with liquidity after the bubble burst.

I was critical of the Federal Reserve for excluding the huge asset class known as stocks from its analysis in the late 1990's. Being the caretaker for the economy as a whole means you should watch every asset class for inflation and every sector for its ability to impact growth both long run and short run.

I was critical of the extremely low interest rates we saw a few years ago. Recall that the recently ended housing boom began with a rise in house values at a time the rest of the economy was in a recession, a strange anomalie. Interest rates did not need to be that low to revive the rest of the economy. Once the prices of houses started to escalate sharply the Federal Reserve should have started a gradual rise in interest rates. This would have smoothed the curve for the class of people who took out adjustable rate mortgages (ARMs). It probably would have prevented prices and the pace of construction from overshooting. It would also have begun fighting non-construction inflation earlier in the economic cycle.

The Fed lately always seems to be compensating, or overcompensating, for earlier mistakes. Jacking up interest rates every consecutive meeting in 2005-2006 might have been necessary to fight inflation, but it created a huge class of people whose re-adjusting ARMs have led to personal despair and widespread anxiety about the housing market.

So where do we go from here? While inflation is a long term danger, the greater danger right now is the readjusting of ARMs. The Fed caused rates for ARMs to be artificially low. They should take some responsibility for the mess.

If I were on the Fed (fat chance) I'd be arguing for two consecutive half-point cuts. This is despite the fact that I'm not an easy money guy. It is an intensive care treatment for victims of the Fed's past mistakes. It would mean that ARMs coming due during this period would reset at much more reasonable levels for the fools that bought the instruments without thinking seriously about the implications.

Then I would pause and watch. If, despite the cuts, the economy moves into a recession or a very-low growth period, more cuts would be warranted. I think it is more likely that following my 1% cut advice the housing market and mortgage markets would stabilize and the economy as a whole would grow at a good pace. If that happened, then quarter point rises once per quarter would be justified to fight long term inflation.

But I'm not the Fed. Based on the past behavior of Fed, I think it will tend to do nothing until it has to do something too fast, and then it will overdo. It will act like a stupid cow, and then it will jerk and stampede. Its job is to smooth things out, but the wrong people (subject to the wrong pressures from the wrong friends) have been assigned to that job.

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