The Fed, Crop Prices, The Dollar, and Moral Hazards

Ever since the Fed began to precipitously drop rates starting in September, a debate has been rekindled. Is Fed policy creating a moral hazard. This debate has continued for quite a while. In fact, in the 1990's many investors accused Alan Greenspan of committing to policy that created a moral hazard in financial markets. In the 1990's, there was something known as the Greenspan put. This was the belief among many traders and other investors that Greenspan would be a lot more aggressive in lowering rates and boosting the stock market than in raising them. Of course, this had a lot more to do with perception than any specific policy that Greenspan created, and this wisdom was blown out of the water when Greenspan began raising rates aggressively at the end of 1999.

These days there are two competing schools of thought. The first school of thought believes that when the Fed acts to stabilize a struggling economy it encourages reckless behavior because the culprits perceive the fed as an organization that will bail them out if need be. The other thought is that acting to stabilize the economy is not a moral hazard but rather creating the right environment to do business.

This debate will not be solved here, however it has great significance to two other things I want to discuss: world food prices and the Dollar. One thing is clear. The Fed's aggressive rate drops have put further pressure on a dollar that was already weakening. Now, most people don't know this but food prices are measured in Dollars. Thus, the weakening Dollar has contributed to the steep climb of world food prices. As this article points out, relatively low interest rates will put upward pressure on all sorts of things.

Nonetheless, the Fed opened up the old playbook and cut rates aggressively when subprime loans blew up. This cemented higher inflation into place, crushed the dollar, pushed commodity prices up sharply, and created major problems in the energy, airline and agricultural marketplaces. And just like the 1970s, it is now popular to argue that the world is running out of resources again.

So, let's review what happened since September. At that time, the housing crisis first emerged as significant issue for the Fed. The Fed sprung into action lowering interest rates more than 3% in less than six months in order to stimulate the economy. When Bear Stearns got into trouble, the Fed stepped in there too in order to save the company from total collapse. The Fed felt that Stearns' total demise would simply shock the markets too much. Furthermore, all of this loosening of money has put downward pressure on an already weak dollar, which in turn put upward pressure on several commodities including oil.

The Fed's insistence on propping up this weak economy may in fact lead the same economy to significant inflation. This brings me back to an idea that was first advanced by Steve Forbes

Again, the magnitude of what has happened is a result of fundamental errors made by the Federal Reserve and its overly easy monetary policy. These errors were compounded by the Bush Administration's weak-dollar policy (pursued in the hope of improving the U.S. trade balance). The Treasury Department was applauding, instead of fighting, the mistakes of the Fed.
Bottom line: Money should be a fixed measure of value, just as an hour has 60 minutes, a foot has 12 inches and a pound has 16 ounces. Fine-tuning and guiding the economy is a harmful undertaking for a central bank. If policymakers learn that lesson from Greenspan's era and its aftermath, then, perversely, Alan Greenspan's legacy will be a positive one.

There continues to be more evidence that the current Fed philosophy is fatally flawed. The Fed follows the philosophy that it's role is to stimulate a weak economy and slow down a strong one. Forbes believes such a belief is nothing short of hubris...

Since World War II most countries have regarded monetary policy as a critical instrument (the other biggies being government spending and taxation) in regulating the economy. If economic activity is slowing, so the thinking has gone, the central bank should rev up the printing presses: The extra money will stimulate growth. Conversely, if the economy is growing too quickly, the central bank should tighten up on money creation, slowing things down to avoid the economy's careening off the road in the equivalent of a car wreck. The longest-serving Federal Reserve Chairman, William McChesney Martin Jr., liked to say that it was the Fed's job to take away the punch bowl just when the party really gets going.

Whether Forbes is correct in his belief that our economy is in fact way too sophisticated the way that the Fed believes it can is of course still up for debate. What should be troubling about current Fed policy is how often the Fed fixes one thing only to break something else. I have already pointed out how current Fed policy has contributed to putting downward pressure on the Dollar which spawned exponentially increasing commodities prices. Greenspan was so concerned with the weakening economy that he dropped rates to levels that became irresponsible and that was a precursor to the excesses of the housing crisis.

One other positive side effect of re focusing the Fed only managing the dollar is that such a policy won't lead to creating problems in other parts of the economy. It also won't contribute to a moral hazard which of course continues to be debated. What Fed policy since the end of 1999 should have taught all of us is that the Fed has lost its way. It is time for a serious debate on the role of the Fed.