Fed: Sending the wrong signals: Business Line: 12th April 2008

The Federal Reserve appears to be chasing a crooked shadow. Let us track its approach to policy since last August. It has turned Keynesian instead of being Monetarist by preferring to fine-tune a rules approach.
There has been too much of fine-tuning, with the assumption being that piece-meal moves help. The discount rate has been lowered eight times since August while the benchmark rate has been lowered six times. Add to these, oodles of financial windows be ing opened up quite liberally.Factors at work
There are evidently three factors at work. The first is growth. There is a feeling that growth is retarded due to lower consumption and house-buying. Therefore, interest rates need to be lowered. Besides, unemployment has also been rising in the last two months — primarily in the financial and real-estate sectors. This bad combination leads to the second factor — politics.
With elections around the corner, the George Bush Government would not like to be seen as one which brought growth down due to stringent monetary policy action. Besides, stagflation could be doing the rounds in the US, where prices could be increasing due to the commodity boom and unemployment rising simultaneously.
This brings back the déjÀ vu of the 1970s which should not be replicated. And, third, there is the financial mess that needs to be cleaned up, and the Fed has decided that it should not remain a mute spectator. Lending is now possible to non-banks and it has also pledged $200 billion of treasuries to be exchanged for mortgage-backed bonds issued by Freddie Mac and Fannie Mae and other private companies.
Lowering interest rates
The stagflation dilemma is real. If growth has slowed down, then interest rates have to come down. However, when the problem is structural, as today, lower interest rates do not help.
Today, banks do not want to lend because they are not sure of the quality of the asset. And they do not want to lend to other banks because they are not sure of their creditworthiness. So, liquidity is not the issue. People do not want to borrow to buy houses, and banks to not want to lend to the owner or builder because the asset has become tainted. And there’s the rub. By lowering interest rates, one may end up creating a demand-pull spiral which may supersede the cost-push inflation which, according to the Fed, will soon be controlled.
The Fed’s actions are also directed more to bailing out the failed financial firms such as Bear Stearns. The issues raised are several. The first is whether or not it is the duty of the Fed to do so. After all, if funds are not being invested properly, the regulator should not bother. But the Fed has to bear judgment that a financial failure has repercussions across the sector and cannot be treated as an anomaly. This leads to the second question of whether financial crises should be allowed to play their full role.
Going by the Schumpeterian doctrine of creative destruction, such crises are needed to ensure that the bad is separated from the good. This is so because during boom times, it is but natural that there are players who overplay the risk card and suffer injury. In such a case, the Fed or central bank should not bother too much, especially if it is fund and not a bank. Incorrect signals
Third, there is the issue of moral hazard. By not allowing a Bear Stearns to fail, the Fed is sending incorrect signals to the sector, that others too can gamble, and even take in huge bonuses with an implicit assurance that if things fail, they will not be penalised as the Fed is there to take care of their interests.
But protagonists of the Fed’s approach claim that it is precisely because the Fed sat back and did nothing that the Depression of the 1930s happened. Thus, by intervening, the Fed has pre-empted a crisis that could have crossed several continents.
The way things are shaping up now, it looks like the Fed may just be preparing the ground for another boom spell which could have a hard landing. The area may not be known, though the pattern is hard to miss. A rules approach to policy and stern approach towards resuscitation packages is advisable under the circumstances.