Thursday, March 27, 2008

No grade inflation here

How would you grade the Fed's recent policy moves? Here's an answer from the eminent economist and Federal Reserve historian Allan Meltzer:

I would give the Federal Reserve either a C or C-, reflecting an average of one good grade and one poor grade.

The Fed has two responsibilities. Monetary policy should be conducted to maintain economic and price stability. That calls for well-timed changes in short-term interest rates. Credit or lender-of-last-resort actions should maintain the payment and settlement system. This requires the Fed to lend reserves to the market when it lacks liquid assets that can be used to settle claims.

Monetary policy is too lax at present. The Fed has done too much to prevent a possible recession and too little to prevent another round of inflation. Its mistake comes from responding to pressure from Congress and the financial markets. The Fed has sacrificed its independence by yielding to that pressure. As a result, real short-term interest rates are negative. Borrowers are being paid to borrow. Negative real rates were a cause of the current problem; they are not a cure. The Fed must raise interest rates in order to prevent inflation.

On the other hand, the Fed’s credit policy has been good. It has been alert to problems in the payment and settlement system. Banks and financial institutions are uncertain about the solvency of other institutions, so they prefer to hold cash rather than to lend it. The traditional way to solve problems of this kind is to provide as much cash as the market wants. And indeed, the Fed has invented new ways of pumping reserves and liquid assets (Treasury bills) into the market. This has helped to prevent a genuine market crisis—at least so far. The Fed did not “bail out” Bear Stearns. It arranged a sale that wiped out the equity and replaced the management without closing the firm.

The Fed’s only mistake was to guarantee $30 billion of Bear’s portfolio. This action transferred potential losses from the market to the taxpayers. I do not believe the present system can remain if the bankers make the profits and the taxpayers share the losses.