The Mother of All Central Banking Challenges

The market expects no change in the current 2.0% Fed funds rate at this afternoon's FOMC announcement. Looking out over the second half of this year, however, the Fed funds futures market anticipates higher rates.

The December '08 contract is currently priced with a 50-basis point hike to 2.5% in mind. It's anyone's guess if that forecast will hold, or if it's even worthy of pursuit. Meantime, the central bank continues to grapple with the twin risks of inflation and deflation, as Martin Wolf writes in today's Financial Times: "Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one."

It's not yet obvious that the Fed and other central banks are up to the job of collectively navigating the complex macroeconomic waters that define and threaten the global economy in 2008 and beyond. But resolving this challenge, or not, will determine much of what unfolds in the years ahead. The central banks, in short, have their work cut out for them. Hanging in the balance: trillions of dollars of investments, the outlook for the global economy and the livelihoods of the planet's workforce.

Alas, cracking this nut isn't going to be easy. For one thing, much of the experience in central banking is dealing with inflation fighting alone, occasionally interrupted by an outright bout of deflation, as during the Great Depression in the 1930s and Japan for much of the past 20 years. Battling both at once is a rare event, which is to say that the Fed's experience in dealing with such a beast is relatively thin.

Experienced or not, that's the predicament du jour. On the one hand, inflation is bubbling. Although absolute levels of prices generally are rising by historically modest standards, the fact that the trend has been up for some time sends a warning signal that central banks can't, or at least shouldn't ignore indefinitely.

But while inflation bubbles, demand destruction appears to be gaining momentum too. The latest examples include yesterday's news on tumbling home prices and plunging consumer confidence.

The hope remains that the demand destruction will derail any inflationary spiral, leaving the economy in relatively good shape for the next upturn. That, at least, has been the Fed's strategy: lower interest rates sharply without fear that the cuts will spark lasting inflation, courtesy of the demand destruction.

It's a nice theory, and it may yet work out. But what if it doesn't? What if inflation doesn't recede and demand destruction continues apace? That's called stagflation, and it's a central banker's worst nightmare. And for good reason: there's precious little track record in the history of monetary policy for overcoming the problem. One exception of a sort was during the Volcker tenure in the early 1980s, when political considerations were cast asunder and an all-out effort to break inflation's back were embraced directly and forthrightly. Of course, winning the war over inflation came at a temporarily hefty price in terms of demand destruction, a fact that only reminds that central banks aren't really up to the task of fighting a two-front war.

But ready or not, the twin fronts are here. Further complicating matters is the necessity of fighting the war on a global basis. In a globalized economy, the benefits as well as the challenges are spawned by the U.S., Europe, Asia and Latin America together. As such, the proper policy responses ultimately must come in concert too. Indeed, now that globalization has taken root, the rules can't be temporarily suspended for central bankers.

That doesn't mean that all central banks should be doing the same thing at the same time. In fact, one could argue that an enlightened and effective policy of central bank coordination these days demands a mix of policy responses that are at once appropriate for the home country while positively supportive of the best interests for the global economy. So it goes in a world that has multiple currencies, multiple monetary policies, multiple economic trends, and multiple inflation rates.

But while the case for coordinated action is strong, it's not clear that it's imminent or that the central banks are up to the multi-dimensional task. This is not the challenge of yore, such as the Plaza Accord of the 1980s, when the objective was simply driving down the dollar vis a vis the Deutsche mark and yen. In many ways, that was a one dimensional task with clear objectives and an obvious path to success.

By contrast, today's challenge is multi-faceted, with objectives including:

* lower inflation
* enhance growth prospects for the global economy
* reduce the trade imbalances between the U.S. and Asia
* soften the pain from the ongoing corrections in the real estate and financial markets but without promoting too much growth, which could ignite even higher commodity prices, which in turn could elevate inflation
* and all the while keep the dollar--the world's reserve currency--from crashing

Perhaps success on those fronts is possible only in a world with one global central bank overseeing one global currency. Alas, ours is a world with many central banks, which share conflicting agendas and a range of political pressures that don't always inspire an intelligent monetary policy. Like it or not, this is the world we live in, and the future begins now.

Comments

[moonbat1775]

"Perhaps success on those fronts is possible only in a world with one global central bank overseeing one global currency. "

The author must be trying to bait his readers. I have another suggestion: How about we get governments (at least ours) out of the money business all together? Is economic freedom too hard a concept to grasp? Or at least allow competing currencies. Or is competition a bad thing?

Read Ron Paul's book for a clue on how to get out of the recurring messes that central banking brings us.

[documentaryman]

Accurate and insightful analysis with no solution. Perhaps the answer lies outside of monetary policy? If energy cost is the root of all inflation, then a comprehensive energy policy would do the most good locally and globally. Why aren't the governments of the world pushing for sustainable energy technology as a way to fight inflation and benefit the working man?

[gabe borenstein]

For the record,the FF futures reflect a speculative consensus of what the FED will decide via the next meeting.It suffices to say that 80% of the time that consensus is wrong .More importantly ,less than 20% of the futures markets investors(speculators ) make money .The sequential events that would follow after the rate hikes would be self destructive to the FED ,ECB and most of the other Central Banks .Whatever vestiges of the economic growth are left ,they are a function of unprecedented leverage being utilized by the speculators including the hedge funds.The consumers disposable income has been decimated globally and the consumption is maintained by the record per capita debt.
The inflation?is not an issue in the U.S .At 3.8% ,CPI is marginally higher than the average inflation over the past 20 years (approximately 3%).Substitute the home prices instead of the rents in the CPI and inflation becomes a marginal topic.More importantly ,in any cycle since 1929 ,the home prices were the most effective barometer of the true inflation,as they would increase in price at the implied rate of inflation or higher.In the current cycle ,the home prices have collapsed in certain geographic areas at the rate comparable to 1929. What continues to drive the inflationary perception is the price of the crude oil. The crude had became the most speculative commodity in the world driven by the record leveraged speculation. No analyst /strategist can explain the explosive price hikes based on the change in supply /demand distortions. As Indian and Chinese economies significantly decelerate in the period ahead ,and the other emerging market economies follow ,the oil demand myth will evaporate.Deflation not inflation will become Central Bank's focus.
I would like to note that the news eminating from Nigeria has been one of the dominating catalysts for the speculative fever in the crude market .
If this is a truly serious crisis ,why arent certain governments subsidizing oil extraction from sands(Canada).One of the issues(oil shortage) appears to be inability of most of the refineries to "crack"the heavy crude-if this is the case ,then why aren't we paying attention to the new technology developed by a small Canadian company ,that would accelerate the refining of the heavy crude.In the end if you impose punitive margins on the key futures markets ,I.E COMEX,CBOT and NYMEX,I believe that the commodity price would implode to the level indicating the true demand.The Central Banks will face the real culprit ,deflation and ease aggressively .This will establish a base for a record noninflationary recovery/growth. All said and done ,the economies outside the U.S ,face a major deceleration which will implode their markets, causing massive capital inflows into the U.S(dollar flight to quality) ...ergo ,unprecedented stock market rally if for the wrong reasons.
In June of 2005 ,I have predicted the current debacle in an interview with Mark Gilbert(Bloomerg-Londo... too many have followed my logic.On September 18,2007 on the Bloomberg TV(Brian Sullivan),I have predicted uprecedented financial crisis based on the subprime debacle-not too many takers. Two weeks before 1987 crash ,I have informed my clients about impending "crash"-not too many takers.In late 1999,In my meeting with Dottore Menginni (portfolio manager of Vatican(then),I have predicted the impending high tech implosion-i think I have convinced him. Now that the universe is discussing recession? I am very bullish on the U.S ,if for the wrong reasons.Only the FED can derail unprecedented rally/recovery ahead via restrictive monetary policy.History shows that the FED was responsible for evey "bust"includ... 1929(raising rates to reduce speculative activity in the stock market.Logical banker would have raised the margins to 100%).
I believe that the risk of a global implosion are so great ,that the FED will create an accomodative environment for a recovery.

[francis schutte]

Markets in silent expectation for what the Oracle is to announce today.
 Wednesday has become the Oracle day where the Gods communicate their will to the people through the voices of Bernanke and the media amplifiers. Since the truth has been cooked (in the USA) or is hidden (in the EU), less and less people understand what is being said or meant.  It is like navigating in the north hemisphere where the magnetic north is degrees away from the true north. If the route is not corrected, the vessels end up nowhere. Black boxes start to fail because the input is incorrect and short term technical analysis is being distorted by the daily interventions of the Plunge Protection Teams and the market volatibility..the website goldonomic.com has more

[iThinkBig]

Agree Gabe Bornstein and agree strongly with Documentarman comments, the energy asset class in the U.S. needs strong subsidies and sustained political will behind it. Right now we have neither and deflating assets, job decimation accelerating and no asset class cushion to soften the freefall. The Fed will do what it can short-term but I see no other way in monetary policy then to do anything else but conduct a Paul Volcker. The energy investment backed by Treasury is the safest way to protect America's national security and restoration of our financial sytem. That regulation is coming down the pike in financial market is a given by either political party. Jail time is needed for some including those at the top. This was global theft on a scale never seen before in history and those that know the line in the sand between greed (healthy and good between man-sized competitors) and theft on the little guy.

[flow5]

You can't manage the money supply with interest rates.

"That's called stagflation, and it's a central banker's worst nightmare. And for good reason: there's precious little track record in the history of monetary policy for overcoming the problem."

The record is very clear. Policy should mimic 1966. You encourage real investment by steering savings to the financial intermediaries. The only time a commercial bank is a financial intermediary is when reserve ratios are at 100%. The point is that you get the commercial banks out of the savings business (REG Q in reverse, but only for the commercial banks - not the financial intermediaries).

What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time/savings deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-ban... cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

[flow5]

The proof:

Dr. Leland James Pritchard (MS, statistics - Syracuse, Ph.D, Economics - Chicago, 1933) described (before it's existence, stagflation - 1958 Money & Banking

“The Economics of the Commercial Bank Savings-Investment Process in the United States” -- “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7

“Profit or Loss from Time Deposit Banking” -- Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.