The Fed’s Credibility Problem
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May 17: In response to the discussion this column generated, it has been updated with a response from the author.
The economics world has been having a lot of fun with hedge fund managers.
After several such managers at a recent conference denounced the aggressive money-printing policies of Ben S. Bernanke, the Federal Reserve chairman, the economic blogosphere rose up to mock them.
Many hedge fund managers have been predicting that high inflation and fleeing creditors would send interest rates skyrocketing. Stanley Druckenmiller, Paul Singer, J. Kyle Bass and David Einhorn — all big names in the investing world — have warned against the supposedly runaway central banker. Mr. Druckenmiller said that Mr. Bernanke was "running the most inappropriate monetary policy in history."
And they have been wrong. Those silly hedge fund managers. They don't understand macroeconomics! As Paul Krugman (and many others) have explained, the lack of demand explains why there isn't any inflation and why interest rates haven't risen despite all the money-printing.
Economists and bloggers have been competing to figure out why these supposedly smart guys are so confused. In an astute post, a Berkeley economist, Brad DeLong, explained his theory: Hedge fund managers thought they could muscle the Fed into caving on its big trade, much like they got JPMorgan Chase to cave on the "London Whale" trades. But they fought the Fed, and the Fed won.
Or perhaps they are simply expressing class preferences. They are ideologues, worried about their tax bills and redistribution policies. Hedge fund managers are wealthy. Asset owners hate inflation because it destroys the value of their holdings.
Or, more subtly, maybe it's an expression of preferences in their narrow professional role. These fund managers get paid mainly to manage other people's money. It's much easier to do that when assets are more volatile and when the short-term interest rates are significantly lower than long-term rates. Fixed-income managers like Pimco used to make a decent return buying long-term Treasuries, essentially investing in risk-free assets and charging fees to do it. No longer. Mr. Bernanke has revealed many of these managers to be empty suits — and they are lashing out.
The Druckenmillers of the world have been and will continue to be wrong about a coming debt crisis and runaway inflation. A dose of moderate inflation would help the economy right now. It would spur spending and investment, and ease debtors' plight.
But what these investors are expressing should trouble all of us: they have almost no confidence in the Federal Reserve or the economics profession. And for good reason.
It's impressive that the Fed and many economists have successfully predicted the path of interest rates and inflation in the wake of the worst financial crisis in a generation. But neither the central bank nor academicians managed to predict or prevent the crisis in the first place. The failure dwarfs the accomplishment.
The Fed's track record is out-and-out abysmal. Fund managers remember only too well how Alan Greenspan encouraged the stock bubble of the late 1990s, convincing investors that he would bail them out if the stock market dropped severely. Worse, Mr. Greenspan urged people in 2004 to buy homes by taking out adjustable rate mortgages. Then the central bank did nothing to curtail the housing bubble. (Whether the Fed kept rates too low for too long is hotly debated; in Mr. Greenspan's defense, the credit bubble kept inflating after the Fed started raising rates.)
The Fed began its lender-of-last-resort role in 2007, but did little to avoid or minimize the financial crisis. Once it hit, it did the right thing to flood the markets with money, but — along with the Treasury and a passive Justice Department — let banks and top executives off the hook. And now, asset prices are going wild. Junk bonds are up. Stocks are up. Housing in Phoenix and Brooklyn is going mad.
This prebubble euphoria only undermines the Federal Reserve's fragile credibility. It reinforces the notion that it seems to know only two things: how to inflate bubbles and how to studiously not recognize them.
Flush from their victory predicting inflation and interest rates, some economists discount the worrisome market activity. Mr. Krugman, a columnist for The New York Times, recently urged Mr. Bernanke to ignore bubble talk.
And lo and behold, the Fed chairman gave a talk on the very subject last week.
The Fed needs to convince the markets that it is on high alert for excesses that could cause the next crisis. And it has to come from the chairman. Encouragingly, Mr. Bernanke said the Fed was on the lookout for unusual valuations, high leverage, new and dangerous products and excessive risk-taking.
Alas, the speech had shortcomings. Right up at the top, Mr. Bernanke delivered this laugher: "Of course, the Fed has always paid close attention to financial markets, for both regulatory and monetary policy purposes."
Of course. With notably rare exceptions, as Mr. Greenspan might put it.
Then Mr. Bernanke scared hedge fund managers out of their open-collar shirts and fleeces by reiterating long-standing Fed dogma: that bubbles cannot be identified ahead of time and that "neither the Federal Reserve nor economists in general predicted the past crisis."
Answering questions, he gave an example of what the Fed might be looking for. "Microsoft's stock is worth well more than it was some time ago, and it could still prove to be a bubble," Mr. Bernanke said, "but so far, so good."
Microsoft? Hello 1999! Is this what state-of-the-art monitoring gets us?
But Mr. Bernanke hasn't spoken about what may be a deeper problem: What if the Fed's loose monetary policy, with its giant bond purchases, is harmful?
If the price of lower unemployment were that hedge fund managers get a little richer, of course, we'd take the jobs. And if the choice were between helping someone get a job today or curtailing a potential crisis in the future, you put people to work now (though it depends on how big the crisis is likely to be).
But that might not be the choice. It sure seems like Fed policy is helping only the wealthy, and not doing much for the economy. The net worth of the top 7 percent of American households rose in the first two years of the recovery, while the net worth of the bottom 93 percent declined. The percentage of working-age people who have jobs is dangerously low. Median income was lower in 2011 than it was in 1999. This cannot all be laid at the feet of the financial crisis. Working-age male income has been squeezed for decades. The economy has deeper problems.
Maybe monetary policy is simply reinforcing these trends.
Professional investors see it that way.
"What a lot of hedge fund managers are worried about is the inflation in asset prices, not cost and wages," said James Chanos, a noted hedge fund manager who is left of center. "This is leading to recurring booms and busts, which in addition are exacerbating income inequality."
The Fed has explicitly welcomed rising asset prices as a sign that its monetary policies are working, as lower rates push investors to put their money to work. But something is wrong. Companies are sitting on their profits. Businesses aren't investing and hiring enough.
In fact, the Fed may be inadvertently making things worse. What if it succeeds in bringing average people back into the markets right at the top? Is the Fed setting these poor suckers up to come in to buy from the hedge fund managers?
"The people you are trying to help don't get the message till the end of move," Mr. Chanos said. "You keep impoverishing them."
Now, I'm not remotely suggesting that the hedge fund denunciations are motivated out of a desire to help the unemployed. Please.
But they can read markets, and they can see that the Fed isn't engineering the hiring, inflation and recovery it would like. Instead of dismissing the critiques, the Fed and economists would do well to pay heed.
* * *
Update (May 17):
My piece was not celebrating hedge fund managers. It was not predicting inflation and imminently rising rates or a debt crisis. Nor was the main point to rehash who got the financial crisis right or not.
Lastly, the main point was not to dwell on the Federal Reserve's credibility problem, though I think that's important.
What was my main point? We are four years into the One Percent's recovery. Now, we are in Round 3 of quantitative easing, the formal term for the Fed injecting hundreds of billions of dollars into the economy by purchasing longer-term assets like Treasury bonds and Fannie Mae and Freddie Mac paper. What's that giving us? Overvalued stocks. Private equity firms racing to buy up Arizona real estate. Junk bond yields at record lows. Ratings shopping on structured financial products.
These are dangerous signs of prebubble activity.
But, much more important, quantitative easing is not giving us a self-sustaining recovery and job creation. As I put it in the column, hedge fund managers "can read markets, and they can see that the Fed isn't engineering the hiring, inflation and recovery it would like." There's been a breakdown in the connection between wages and productivity. Labor participation is desperately low.
So are we moving from the bust to the bubble and missing the recovery for average people?
And if so, why?
Many people argue that we need more fiscal stimulus. That's persuasive, but it's clearly not happening with today's Washington.
In response to my column, people have said: What else should the Fed do? Things would be far worse if the Fed weren't buying $85 billion in bonds a month. Look at Europe, whose monetary policy has been almost as big a disaster as its fiscal policy.
But how long do we have to wait? How much more wealthy do the One Percent get to become through speculation — how much house flipping do private equity firms get to do — before we see some sustained improvement in the rest of the economy?
And could it be that with a heavily indebted populace and a dysfunctional banking system still unable to lend effectively, that this round of quantitative easing is having a counterproductive effect? As evidence that the banking system transmission mechanism isn't working well, small businesses are having a hard time borrowing, according to a recent New York Fed poll.
One solution is that the Fed needs to have a heavy regulatory hand to limit speculative activities. Perhaps regulators should raise margin requirements for stocks. Put the ratings agencies on notice that they are watching out for any loosening of criteria. Make these efforts public and keep talking about them.
And then, maybe quantitative easing needs to be refocused away from long-term Treasuries and housing. Maybe the Fed could figure out a way to buy student debt or municipal bonds to support infrastructure.
If quantitative easing is necessary, it should support investment, not speculation.
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