U.S. Federal Reserve Incompetence

Has the US Federal Reserve System (the Fed) changed its monetary policy and strategy? The issue has caused a disturbance in financial markets and agitated analysts for the last two weeks.

The U.S. Central Bank has two objectives as specified by the law: price stability and full employment. Since the summer of 2007 and the beginning of the financial crisis, the Fed has deliberately sacrificed the former, the fight against inflation, for the benefit of the latter, supporting activity at all costs. The priority of Ben Bernanke, the chairman of the Fed, is to avoid a deep recession in the United States linked to the collapse of the banking system and the funding of the economy.

After seeming more orthodox than his predecessor (Alan Greenspan, today criticized after previously being praised), Mr. Bernanke has finally taken action, like Mr. Greenspan, amid warnings and pressure. In nineteen years of chairmanship, Mr Greenspan came up against several recessions and burst bubbles and, each time, opened the monetary gateways wide in order to overcome them.

Using this method, the Fed has decreased the interest rate on a day by day basis by 2.25% between January and April, the fastest decreasing rate in the last twenty years. It has also come to the rescue, under its other guise as banking system regulator, of the Bear Stearns bank, which was threatened with bankruptcy, even going so far as to fund its recovery through JP Morgan Chase.

But in the last two weeks, Mr. Bernanke, and several important members of the Federal Open Market Committee, notably Jeffrey Lacker of the Richmond (Virginia) Fed and Richard Fisher of the Dallas (Texas) Fed, have taken a new line. Mr. Bernanke stated at a conference on the 9th of June that “he would strongly resist the erosion of long term inflation expectations.” Mr. Lacker and Mr. Fisher highlighted the dangers of an inflationary spiral. The determination displayed in the fight against inflation is somewhat similar to that of Paul Volcker (the former chairman of the Fed), who stood out in the eighties by putting an end to the inflationary spiral using a vigorous monetary policy. Financial markets are hoping for an interest rate upturn in the United States, not at the next Federal Open Market Committee (June 23rd and 24th), but by those that will take place on the 5th of August and the 16th of September. This, however, seems difficult to imagine.

Boosting the U.S. dollar

Necessary, first of all, because the risk of recession in the U.S.A. has not disappeared and because, in its history, the Fed has never started tightening credit before the unemployment rate begins to decline. The fundamentals of the American economy are still weak. Housing prices continue to fall, unemployment is on the rise, investment is slowing down, confidence is diminishing among company bosses’, the car industry is experiencing a slump, States and local authorities are reducing their spending, credit distribution continues to decrease, and the positive effects both on the purchasing power of households and on consumption of tax reductions should start to wear off in the coming months.

In fact, the Fed’s new approach still has the same aim: to avoid a deep recession. It is attacking the biggest immediate threat to economic activity in the United States, bigger than the credit crunch: soaring petrol prices.

Giving a bit of a boost to the dollar, worrying over its weakness, as Mr. Bernanke unusually did three weeks ago, or suggesting that the Fed could increase its rates is about the only way available to Mr. Bernanke to influence the price of oil per barrel. A study carried out by the Dallas Fed shows that there is a fairly tight correlation between the increase in oil prices and the weakness of the U.S. dollar. According to calculations, if the American currency was as strong today as it was in 2001, the price of a barrel of oil would have been at least 20 dollars lower at the beginning of the year.

This strategy, consisting of attempting to strengthen the dollar by getting rid of the threat of an increase in rates, is remarkably similar to a confession of incompetence. Mr. Bernanke could hardly raise the interest rate in the United States without attracting anger from the public, the government, the two candidates of the November presidential elections and both Democratic and Republican representatives.

In theory, the Fed is independent but it is still affected by its political and social environment. Yet statistics show that the American people are losing their jobs, their homes and their trust.