Wishing Warsh Good Luck With Pre-emptive Tightening of Monetary Policy

On Friday, Federal Reserve Governor wrote an op-ed piece in the Wall Street Journal titled “The Fed’s Job Is Only Half Over.” In this piece, he suggested that while “…longer-term inflation expectations are stable, and economic conditions are likely to warrant exceptionally low levels of the federal-funds rate for an extended period…prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.” As a sign of just how addicted our economy is to cheap money, this latter phrase sent chills down a lot of spines and confused a lot of pundits. The market stumbled a bit just as it did in mid-June when the G8 Finance Ministers went public with the notion that easy money could not flow indefinitely.

I wish Warsh “good luck” trying to implement a pre-emptive aggressive tightening of monetary policy because most of our experience for almost three decades has been declining rates. Relatively cheap money is what sustained the last bull market, and it is the current hope for continuing to fight off the bear. I have argued here before that there will be not be enough political will in the Federal Reserve to tighten policy ahead of a sustained recovery that satisfies business, bankers, and the government. This thesis alone keeps me long-term bullish on commodities and TIPs.

Having said that, I must commend Warsh for otherwise being relatively measured in his commentary. The media’s laser beam focus on his call for pre-emptive monetary policies has missed an important point from Warsh: “we should maintain considerable humility about optimal policy…market participants and policy makers alike should steer clear of ironclad policy prescriptions.” In other words, we are and will remain in unprecedented economic territory, and there is simply no way anyone can speak with certainty on what specific actions need to take place and what outcomes we should expect from those policies (even as we guess with a little more certainty about how the political battles will play out).

I find it interesting that Warsh proposes watching the behavior of financial markets for clues as to how to proceed: “…the level of asset prices and associated risk premiums, and gauging their trend and durability, will demand careful assessment.” Under most of the Greenspan days, we commonly heard that the Federal Reserve paid little attention to the vagaries of the markets in setting policy. That stance only began to change in the latter stages of the housing bubble (for example, Greenspan belatedly and obtusely warned in 2005 about an “unsustainable underlying pattern” in housing markets). Even more remarkable, we read last year about the potential for the Federal Reserve to study active intervention in preventing bubbles. However not since Volcker took up the battle against raging inflation in the early 1980s have we seen any active attempt by the Federal Reserve to take down the price and value of anything…except maybe the U.S. dollar. So, I will believe the words, when I smell the action.

Be careful out there!

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