Ben Bernanke has indicated that the Federal Reserve will redouble its efforts to communicate clearly about the outlook for the economy and monetary policy.
Plain talk won’t much improve the Fed’s credibility, because its problems lie, not in its communications, but in its reliance on textbook economics and arcane econometrics to shape policy, and the Fed’s failure to grasp the consequences of globalization and decaying financial institutions for the conduct of U.S. monetary policy.
From June 2004 to June 2006, the Fed raised the federal funds rate 17 times. Meanwhile, China and other foreign central banks were buying billions of U.S. dollars on foreign exchange markets to keep their currencies and exports cheap to American consumers. Central banks converted those dollars into U.S. Treasury securities, which kept U.S. mortgage rates low, even as the Fed raised short-term lending rates to businesses.
Even with suppressed mortgage rates, the run up in housing prices should have paused sooner than it did, as mortgage payments for new homeowners outran increases in salaries. However, financial engineers at Countrywide, Bear Stearns and other banks incubated creative mortgage products that artificially elevated home affordability, and hawked risky mortgage-backed securities to gullible investors.
Now, those mortgages are defaulting and the bonds are proving worthless, housing prices are tanking, and the economy is teetering on recession. The Fed, by cutting short-term interest rates alone, cannot save the economy.
Simply, most bond investors will only buy mortgage-backed securities from Fannie Mae and other federally charted banks. Their lending is generally limited to mortgages less than $417,000 and to the best borrowers.
Investors will no longer buy mortgage-backed securities from Wall Street banks, because these institutions have balked at reforming lending practices, compensation structures and bond rating methods that caused the subprime meltdown. But lending by these banks is needed to finance creditworthy homebuyers who don’t qualify for Fannie Mae loans. Without those mortgages home values and residential construction cannot regain their footing, and slower growth or a recession seem inevitable.
Yet, the Federal Reserve behaves as if calibrating the federal funds rate will do the trick, because models of the economy, taught on the blackboards at Princeton, say they will. But those models assume strong, credible financial institutions that permit the Federal Reserve to regulate the availability of loans by adjusting bank liquidity through short-term interest rates and similar levers.
Additionally, Federal Reserve thinking is dominated by econometric modeling, which seeks to divine eternal economic truths from statistical relationships culled from past behavior.
Those models are the same kinds of contraptions that caused the 1998 failure of Long-Term Capital, a hedge fund founded by two Nobel Laureates. Similar models were recently used by Standard & Poor’s to underestimate the riskiness of securities backed by adjustable rate mortgages.
Comparing recent data to econometric findings causes the Fed to lag businesses and markets in identifying and correctly reading threats to growth and price stability. For example, the October 31 Federal Reserve policy statement indicated further interest rate cuts would not likely be needed, even as private investors saw the subprime crisis building to cause greater havoc.
Other gaffs followed, for example, when the Fed disappointed markets by cutting the federal funds rate by only a quarter point on December 11-within days, the Fed was forced to further shore up bank liquidity with the Term Auction Facility.
These missteps were not the poor communications of Fed intentions but rather a clear breakdown of the policymaking apparatus to grasp the erosion of confidence among investors in the competence and integrity of Wall Street’s once venerable financial houses.
As Fed Chairman, Ben Bernanke cannot, alone, make U.S. policies to respond to Asian intervention in currency markets or regulate U.S. banks. He must cooperate with Treasury Secretary Paulson. However, as with federal tax and spending policies, he can articulate the consequences of foreign government and U.S. bank practices for the Federal Reserve’s stewardship of the economy, and recommend specific changes in U.S. policy and regulations that would better assist economic growth and price stability. On repeated occasions he has failed to do so in a timely fashion, or altogether.
Textbook economics and elegant econometrics in academic journals are good for teaching adolescents about the workings of markets, but they don’t provide adequate information for crafting monetary policy in a complex and imperfect world.
It recalls the biblical passage, “When I was child, I spoke like a child, thought like a child, and reasoned like a child. When I became a adult, I no longer used childish ways.”
Ben, what works for the schoolmaster does not work well for one who would be master of the economy.
PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.