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Will Fed "Soft Money" Create Hard Times for U.S. Economy?

Economics / Quantitative Easing Mar 17, 2010 - 06:53 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleMartin Hutchinson writes: For a U.S. president, nominating Fed governors is a little like nominating Supreme Court justices: Since they serve a 14-year term, you have the chance to shape the U.S. Federal Reserve for a decade after your administration ends. What's more - even though Fed governors are subject to confirmation by the U.S. Senate - you're far less likely to have trouble getting them through than you do with the Supremes.

That's why U.S. President Barack Obama's current chance to nominate three out of the seven Fed governors is legitimate front-page news - and isn't merely the "inside monetary baseball" trivia that occupies much of the daily business section. Probably two of those three governors still will be serving in 2020, long after President Obama has published his memoirs.

The bottom line: One of President Obama's legacies will be a "soft money" Fed.

Peter Diamond, one of the three names the White House announced last week, is high quality by any standards: He's an MIT economist, with several important economic theorems to his name. He will prove to be very useful in a crisis, if only for his ability to figure out the best course of action - even as he's being badgered by lobbyists and politicians.

Diamond is also an expert in behavioral economics, which means he won't be too seduced by fancy mathematical models resting on obviously false assumptions like economic rationality. However, on monetary policy he's an unknown quantity.

A second, Sarah Raskin, is a regulatory specialist, currently Maryland's commissioner of financial regulation. Monetarily, she is also something of unknown quantity, though the odds are she would tend towards the soft money wing on the Fed - Maryland has always had that kind of reputation, rather the opposite of Boston.

The third - and most important - of President Obama's probable nominees is Janet L. Yellen, president of the Federal Reserve Bank of San Francisco. With 30 years as a monetary economist, three years as a Fed governor in the 1990s and six years at the San Francisco Fed, she's unquestionably qualified. Yellen is even married to an Economics Nobelist (George Akerlof), with whom she's published numerous research papers.

But here's the rub. Yellen has a reputation as a "soft money" supporter, and recently said the rate of inflation was "undesirably low." Even more alarming: She believes that in 2004 - her first year in the job - the U.S. economy was in danger of deflation .

In this view, Yellen echoes the beliefs of her new boss, Federal Reserve Chairman Ben S. Bernanke. To see why that's a cause for alarm, consider where inflation actually stood at that point. Reported consumer price inflation in 2004 was 3.3%, but 30% of that figure comprised "owners equivalent rent," or OER, an artificial construct imported into the Consumer Price Index (CPI) in 1980.

Replace the 2.5% rise in "owners equivalent rent" with 2004's 16.2% rise in U.S. home prices, and the actual living-cost inflation being experienced by consumers comes to 7.4%.

The upshot: Deflation was actually the last thing the Fed should have been worrying about at that time.

If the Fed is still going to be blathering on about deflation in a year in which inflation soars past 7%, we're in trouble. Unfortunately, it looks like that's the way it's going to be unless Diamond turns out to be a secret Paul Volcker clone.

With these three new governors plus Bernanke and Bill Dudley, president of the New York Fed, the soft-money types are going to have a pretty solid majority of the policymaking Federal Open Market Committee (FOMC) - which establishes target rates that help determine overall U.S. interest rates - all the way through the end of 2012.

With the U.S. federal budget deficit well above 10% of gross domestic product (GDP), the chances are high that by the end of a four-year period of very low interest rates we will have locked in an inflation rate that makes the 1970s look tame. Maybe we can avoid the Weimar Republic's 1923 hyperinflation rate of a trillion percent a year, but we're heading in that direction.

Now more than ever, gold, oil and commodities look like a good bet. The same holds true for gold-, energy- and commodity-producing companies whose reserves are in politically solid locations.

With three years of "soft money" ahead of us, the prices of oil and gold could get pretty much to nosebleed level. You probably want most of your money outside the United States, as well - we have enough exposure to these crazy policies just by living here.


Money Morning/The Money Map Report

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