At the Fed, Precedent Takes a Holiday

by: James Picerno

These are strange days in the global capital and commodity markets. The macroeconomic terrain isn't quite familiar either. No wonder, then, that central banking isn't quite itself either.

The weird aura is second to none in these United States, where the Federal Reserve is battling, among other things, a bout of the unfamiliar and unusual. Two recent commentaries by observers from the dismal science offer a sampling of how life in the central banking trenches is something other than par for the course of late.

"Recent Federal Reserve activities suggest that Chairman Ben Bernanke went from being in charge to losing control of the Federal Reserve in the span of a few days," wrote Michael Cosgrove (an economist who runs the Econoclast consultancy in Dallas and is a professor at the University of Dallas) in an op-ed this week in Investor's Business Daily. As a result, Cosgrove wonders if the longer-term direction of monetary policy is "up for grabs" after the election.

The fact that Fed Chairman Bernanke has broken with recent precedent and talked so openly and forthrightly about the dollar is one clue that's something's a bit amiss at the central bank, Cosgrove suggests. Another curious sign is the fact that there's a relatively high degree of public dissent among Fed members in 2008. That's raising an unusual amount of questions about whether the central bank has a sound monetary policy plan or is struggling with internal fighting.

"It looks like Bernanke, an academic, is attempting to run the Federal Reserve like an academic institution," wrote Cosgrove. But "Bernanke can't run the Fed like an academic institution. He needs to learn that quickly, or he will be leaving the Federal Reserve when his term is up in 2010. It may already be too late."

Meanwhile, there's the issue of the two open vacancies on the Fed's Board of Governors, which may soon turn into a third with the pending retirement of Frederic Mishkin in August. "The balance of power at the Federal Reserve appears to have shifted from Washington to the regional Federal Reserve banks," wrote Thomas Higgins, chief economist at Payden & Rygel Investment Management, in a note to clients yesterday.

Higgins advises that the regional Fed bank presidents are relatively hawkish on monetary policy compared with the balance of voting members of the FOMC. As a result, the vacancies on the board give the hawks more influence over monetary policy, as Payden & Rygel's graphic below illustrates.

click to enlarge

Nonetheless, Higgins thinks rate hikes aren't imminent. Why? Quoting from his research note, he wrote:

1) The lower fed funds rate has yet to translate into lower borrowing costs for the average American.

2) The Fed would appear confused and damage its credibility with the financial markets if it were to raise interest rates so soon after cutting them.

3) Higher interest rates would aggravate the pain in the housing market especially given the large number of adjustable rate mortgages that are in the process of resetting to higher interest rates.

Meantime, Cosgrove and others speculate that the vacancies are politically motivated. Senate Democrats are waiting for the election and the hope that a Democratic President will appoint Fed heads who are more dovish.

"So we could see sharply higher tax rates on capital and earned income along with movement to a less open trade policy — plus a shift toward appointing people with an easy money bent to help lessen the real debt burden of the U.S. government," Cosgrove predicted.

Perhaps. But at this point, there are more questions than anything else. There's a fair amount of risk with a Fed in some amount of disarray at such a critical juncture in the global economy. All of which reminds us of the ancient Chinese curse: May you live in interesting times. Certainly in the world of economics and finance these days there's no trouble meeting that standard.