Who's Running the Fed?

The news media reported Wednesday that Fed Chairman Ben Bernanke had spoken on the phone with former Treasury Secretary Robert Rubin after the Fed's decision to keep interest rates unchanged in August. Mr. Bernanke also had conversations with Lewis Ranieri, founder of Hyperion Capital Management, and Raymond Dalio, president of Bridgewater Associates.

Mr. Rubin had a long career at Goldman Sachs and is now chairman of the executive committee and a director of Citigroup. Mr. Ranieri, according to Bloomberg News, is a former vice-chairman of Salomon Brothers (now part of Citigroup) and is 'a pioneer in the mortgage-backed securities market'. Bridgewater is the fourth largest US hedge fund with assets under management of $32 billion, according to HedgeFund Intelligence's Absolute Return magazine.

Subsequent to these discussions, the Fed reversed its inflation-fighting stance and made aggressive interest rate cuts in September. It does not take a huge stretch of the imagination to speculate that Mr. Bernanke was more than a little influenced by his Wall Street contacts. His discussions with bankers and investors probably emphasized the near-term benefits of cutting rates, and likely downplayed the longer-term damage of moral hazard and lost credibility. These conversations were more likely to highlight the imminent risk of a credit crunch and the need for urgent intervention, and less likely to voice concern on the state of the US dollar and the emergence of inflationary pressures.

The power centers of Wall Street, big banks and hedge funds, now run the Federal Reserve because there are now too many large banks and too many large hedge funds that are too big to fail. It was relatively easy to deal with one LTCM collapse in 1998. Imagine a dozen LTCMs taking place at the same time. One major failure could cascade through the system and have catastrophic consequences. How did we get here? Perhaps the repeal of Glass-Steagall and the explosive growth of unregulated hedge funds are a good explanation. None of this is a good omen for the future.