“Humble”  is typically not an attribute associated with the Federal Reserve  (Fed), especially in light of the trillions of dollars recently printed.  Yet, in his latest press conference Fed Chairman Bernanke called for  humility: we must be humble in setting monetary policy! The problem is,  Bernanke’s definition of the word “humble” appears to be something  entirely different from what – in our humble opinion - common sense  might expect.

We  have previously argued that the only reason the Fed gets away with  printing so much money is because that money doesn’t “stick”.  Technically, the Fed doesn’t actually print money, but buys fixed income  securities with ever-longer maturities (mortgage-backed securities and  Treasury securities). To purchase those securities, money is literally  created out of thin air; a simple computer entry is all that is required  to credit the account of a bank at the Fed in return for the purchase  of a security. These purchases are reflected as an increase in assets on  the Fed’s balance sheet, with an offsetting increase in liabilities  (cash in circulation – Federal Reserve notes – are a liability for the  Fed). When proceeds from a maturing security are re-invested, no new  money is being created, but the balance stays at an elevated level; as  such, when QE1 or QE2 “ended”, the amount of money that had been printed  was still in the system. Some economists argue that such policies don’t  amount to “money printing” because banks haven’t done much with the  money they received (the velocity of money has not shot up). Our  response to that argument has been that if you were to give a baby a  gun, just because the baby doesn’t shoot anyone, doesn’t mean it isn’t  dangerous. So, to us, being humble should focus on being most concerned  about the potential side effects of monetary easing.
A  key reason why all the money that has been printed hasn’t made it to  the real economy is because major deflationary forces are present, as a  result of the financial crisis. In our assessment, in the run-up to the  financial crisis, the Fed had lost control over the credit creation  process. That is, consumers used their homes as ATMs, creating their own  money. Similarly, financial institutions found ways to create their own  money, e.g. increasing leverage by creating special investment vehicles  (SIVs). In the goldilocks economy of much of the last decade, it was  only rational for investors to take on more risk, to increase leverage.  After all, house prices could never fall. However, starting in  2007, risk came back to the markets. As a result, it became similarly  rational for investors to reduce leverage. Unfortunately for investment  banks Bear Stearns and Lehman Brothers, they didn’t have sufficient  liquid collateral to downsize. Similarly, many consumers buried in debt  have been unable to downsize, causing elevated numbers of defaults on  their obligations (mortgages, auto payments, credit cards…) It’s because  policy makers initially lost control on the credit creation side that  we are now witnessing a gargantuan effort to stem against deleveraging,  deflationary forces. We believe this is a key reason why, with all the  money spent and printed, the U.S. can only generate lackluster economic  growth.
In  this environment, it’s likely that the Fed can get away with just about  anything in terms of monetary expansion. But should these policies  work, should all the money that has been printed make it through to the  real economy, the Fed may find itself in a tricky situation. Bernanke  argues that he can raise interest rates in as little as 15 minutes to  contain any inflationary fallout that might occur. In the early 1980s,  former Fed Chair Paul Volcker raised rates to 20% to beat inflationary  pressures. In those days, people complained, but because there was so  much less leverage in the economy, it was bearable. In today’s  environment, 6% appears to be the threshold for countries such as Spain  before commentators believe the International Monetary Fund (IMF) has to  come to the aid of the government. Wait. Paying 6% interest is  considered unsustainable? What type of world are we now living in? More  importantly, will the Fed have the will to potentially crush the economy  in order to contain inflationary pressures? Anyone reading this and  even considering that the Fed may hesitate proves that the Fed has lost  credibility. Credibility requires the perception that the Fed will not  hesitate to beat inflation.
It  is in this context that we have urged policy makers to be humble. That  is, to allow the excesses of the bubble to be corrected, which will in  turn allow for a sustainable recovery. Rather than throwing trillions at  an economy in a scatter gun approach, simply hoping that things work  out as planned, policy makers could let free market forces do their  work. The current environment might be painful, as inflationary  pressures have crept up, although they have mostly been limited to items  the Fed seems to consider “transitory”. Oddly, countries that have a  challenging time recovering from the financial crisis justify low  interest rates by calling inflationary pressures transitory; in  contrast, Singapore recently tightened monetary policy – in our  assessment because they are in a strong enough position to be able to  take measures against rising inflationary pressures. Humble monetary  policy, in our assessment, means not walking on a cliff’s edge, but to  pursue sound monetary policy.
Not  Bernanke. His view of being humble is rather different. In his press  conference discussing the latest Federal Open Market Committee (FOMC)  statement, he was asked to contrast the US and Japanese experiences.  Bernanke argued that the US avoided the Japanese experience because, 
“We acted aggressively and preemptively to avoid deflation”
 
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