Tuesday, January 29, 2008

Grant's Indictment of the Fed

James Grant is back on the editorial page of the New York Times with a scathing indictment of the Wall Street, Main Street and Washington:

Striving so mightily to make one and one add up to three or four or five, Wall Street, Main Street and Washington collectively brought us to the impasse of 2008, in which a debt crisis is superimposed on a downturn in the economy, which is overlaid on a bear market in real estate, which is conjoined with a persistent and worrying weakness in the overseas value of the dollar. As for the crackup in complex mortgage-backed securities, now at the center of the debt predicament, the global bank UBS has justly called it “the biggest failure of ratings and risk management ever.”

But Grant places most of the blame right where it belongs - on the Fed:

It would be asking a lot of an ordinary mortal to hew to the literal truth in a mortgage application when, to the applicant, it seemed as if the money was being offered free. And for 12 full months, from mid-2003 to mid-2004, the Fed set its interest rate, the so-called overnight federal funds rate, at just 1 percent. It took this extraordinary step to ward off the risk of falling prices, or deflation, it said. It would not tolerate too little inflation, it explained, but wanted just enough. At the time, the cost of living was rising by 2 percent a year.

He ends with a prediction:

To lubricate the machinery of lending and borrowing, Mr. Bernanke is likely to make dollars increasingly plentiful. The trouble is that, while the Fed is America’s central bank, the dollar is the world’s currency. It lines the vaults of central banks of America’s creditors, especially the up-and-coming states of Asia and the oil-soaked principalities of the Middle East.

Such institutions hold dollars by choice, and not a few of them chafe at the greenback’s steady loss of purchasing power. For some, Tuesday’s hasty rate cut might be the last straw.

As just about nobody predicted the present troubles, humility is what becomes today’s forecaster the most. So I will offer up a humble forecast. Inflation will, at length, make its way up from the bottom of the Fed’s worry list to the very top. Not for years has it seemed to matter that the dollar is only a piece of paper. But, before very long, that homely fact will push itself back to the fore.

I agree with Grant that in the long term, inflation has been and will always be the problem as long as we have a Federal Reserve fixing the price of credit. That is why as an investment manager I always maintain positions in real assets. In the short run however, I suspect the deflationary nature of the housing bust will keep stated inflation relatively low and allow the Fed to inflate our way out of the current mess. Of course that will only mean a bigger and different mess down the road, but no one in power is thinking about that now.

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