The Obstinate Fed

The Jayhawk's Nest believes that the Federal Reserve Board must no longer have the power to govern and dictate overnight interest rates, aka 'Fed funds rate'. Instead, this rate should be determined by the marketplace, in the marketplace. The rationale for this is fairly straight forward and was stated in an earlier post.

Over the past few years of monitoring the financial markets, it has become increasingly clear that the Fed is too slow to react to the current economic environment. In the most present time, for example, the Fed has been extremely slow to provide liquidity to institutions that are running dry. The mortgage debacle that began in the early summer of 2007, and showed signs well ahead of that time, was simply met with a shrug and a couple of blinks from the Fed. Their chief concern amidst the crumbling of credit was inflation.

The cost-push inflation seen over the past few years has been a result of higher oil demand and higher food prices. This cannot be controlled by over night rates as these goods are price inelastic, i.e. they are necessities. Over the long run, they may indeed become price elastic with technological advances and as consumers get more used to the prices. But, in the short run, this inflation should not be the concern. In fact, the higher oil prices have acted as a tax on consumers as their disposable incomes decrease. Indeed this is what the retail sales data shows - a weakening consumer.

And, so, finally last week the chairman of the Fed admitted to a substantial weakening of the economy and promised substantial liquidity, i.e rate cuts. What's he waiting for?! Rates cuts take at least 9 - 12 months to stimulate the economy and sticking to a rigid FOMC meeting schedule to take policy action, is at best, a dumb idea. They ought to act (as they know they should), and they ought to act now.

So, what should be the Fed's new role? Regulating banks and financial institutions as the currently do, only with greater focus, so that the financial companies are not tempted to sin, i.e. get greedy SIVs and other exotic derivative debt instruments. The actions of the masses on Wall Street indeed pose systemic risks to the economy at large as we've seen.