Is the Fed's Impact Waning?

Several respectable sources are on the record of believing that the impact of the Federal Reserve is waning. John Hussman wrote a very good piece in 2001. He has referred to these ideas often since, but the original piece is the best. Personally, I think Dr. Hussman is flat out wrong on the nature of inflation, but his view of the Fed's irrelevance is still valid if you accept his explanation that:

The main job of the Federal Reserve is to determine the mix of government liabilities held by the public. ...

At present, reserve requirements apply only to "transactions deposits" - essentially checking accounts. The vast majority of funding sources used by banks to create loans have nothing - nothing - to do with bank reserves. ...

The point is simple. Commercial, industrial and consumer loans no longer have any link to bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have actually declined. Look at the one monetary aggregate that the Fed can directly control - the monetary base. Every bit of increase since January 1994 is accounted for by currency in circulation, not bank reserves.

Another economist I follow who thinks the Fed has lost potency is David Ranson of H.C. Wainwright & Co. Economics Inc. Dr. Ranson's argument is that globalization and vast development of financial instruments and derivatives have lessened the Fed's ability to directly impact the cost and volume of credit and therefore their impact on economic growth. Dr. Ranson and his company are prolific publishers of research, but access is limited to subscribers.

John Tamny penned a great piece last weekend that addressed how the impartial Fed gets trumped by politics and the policies inacted by politicians on the impact on the dollar.

The role of politics as it applies to the direction of currencies should not be discounted. Though central banks ultimately control money creation while nominally free of political influence, they have traditionally been outmaneuvered by the politicians, which raises questions about how effective future rate hikes will be when it comes to strengthening the dollar. History shows that central banks are often toothless versus the administration in power when it comes to setting the direction of currencies.

I view the Fed as the last of the socialists. To borrow/steal a phrase from Rex Sinquefield, the only people left who do not believe free markets work are the North Koreans, the Cubans, and the Central Bankers. If you believe in The Wisdom of Crowds, then you know the market will always be more accurate than a group of two dozen "experts" on a committee. The Fed's current model (i.e. worldview) is flawed and thus their policy is ineffective. The economy is clearly slowing as a result of the 425 basis points of rate hikes from 2004 to 2006, yet inflation is worse than when the hikes began, and accelerating. They are likely to make a big mess real soon, and that makes the Fed as relevant as ever.

Comments

[tomnleeryan:]

The Fed may be ineffective in any causality... but they still have a pyschological effect on market behavior. The throngs of brokers and managers are so scared of getting caught behind a market move, they tend to overreact to things they consider signals. As long as this human misbehavior persists, The Fed will be relevant whenever they act, and the market will react.

2007 Apr 15 11:03 AM

[cynic69:]

The Fed has some serious problems. The Fed Chairman is an extreme egotist and is seriously beholden to the administration that hires him and pays his salery. We are seeing the dangerous effects of this connection in the current irrational liquidity driven rally. The Fed chairman is taking terrible risks in order to make the Republicans look good. His hope is that if the citizens are happy they will elect a Republican president in 2008. This massive influx of liquidity is eroding the dollar at a rapid rate. The eroding dollar is causing foreigners to lose vast amounts of money on their investments in the U.S. When they begin to sell their holdings in the U.S. our markets may collapse dramatically. In addition the falling dollar will result in the U.S. having to pay a higher bond rate to entice foriegners to buy our bonds. This is an inflationary trend that will futher erode the dollar. Our economy work much better if Ben would stop meddling and let the market dictate stock prices.

2007 Apr 15 12:10 PM

[Bruce Merri...:]

Right on folks...The Fed has manipulated the economy for 50 years with a combination of money supply and interest rates. The ratio of M2 to the Federal Funds Rate (M2/FFR), is a useful monetary index. When this ratio falls, a year later the economy tanks and a year after that inflation falls. When the economy tanks, the Fed belatedly reverses the index, and a year later the economy begins to recover etc. This has given us our 4 year boom and bust cycle for the last 50 years....until now. The global marketplace has now taken away the Fed's control of money supply.

Fortunately, the U.S. has developed a depth and breadth of academic and industrial infrastructure in recent decades, for which history has no precedent, and which no other nation will replicate in any reasonable time. This phenomenon has generated some 25 million new small businesses since 1982, some 90 million new jobs (offsetting 45 million lost by big companies in doewnsizing and restructuring...a net of +45 million jobs)....and about 94% of all household American wealth (now $56 trillion, up from $3 trillion in 1982). Europeans call this the American Miracle, rewultin in an inflow of about $800 trillion in capital last year for investments. The U.S. has been contributing about 30% of the growth in the World Gross Product every Year (46% in 2006).

Basically, the Fed has become increasingly irrelevant in this global marketplace, but retains a psychological hangover, which still scares people. The Emperor has no clothes?

Bruce

2007 Apr 15 01:16 PM