The inflationary Fed, part II

More observers are beginning to be concerned about inflation, particularly now that the widely-anticipated "recession" has not arrived and the credit scare that may have reached its height in March has been addressed by the creation of new lending facilities.

As we noted in March, those new lending facilities were an effective response that we thought would remedy the immediate financial crisis (although we also noted that they were created too late to save Bear Stearns, contrary to the popular opinion).

However, as we also noted previously (such as in this post from February entitled "The Inflationary Fed" and especially the post after that one entitled "A troubling quotation"), the Fed's recent round of lowering interest rates in an attempt to "steer the economy" is in an entirely different category.

As we wrote in that second post, "Many economic problems have been created by the Fed trying to steer the economy faster or slower using monetary policy, including the current credit crisis." Rather than trying to steer the economy, we argued, the Fed should focus on providing businesses with a predictable, stable currency, and then businesses will grow the economy, not central bankers.

Recently, Congressman Paul Ryan of Wisconsin wrote an article in the Wall Street Journal in which he argued the exact same point, noting that "When the Fed was created in 1913, its principal role was to maintain a sound currency with stable prices" but that in 1978, the Humphrey-Hawkins Full Employment Act of 1978 "changed the Fed's mandate, directing it to focus on long-term price stability and short-term economic growth."

While we agree with the general argument Congressman Ryan makes that the Fed should not steer the economy, we would also argue that the Humphrey-Hawkins Act of 1978 only made more specific the goals enacted in the landmark Employment Act of 1946, which stated that "it is the continuing policy and responsibility of the Federal Government to use all practicable means [. . .] to coordinate and utilize all its plans, functions, and resources [. . .] to promote maximum employment, production, and purchasing power" (full text of the 1946 Act available here). For a good discussion of the history of the Fed's mandate and the debate over whether it should try to steer the economy in addition to providing a stable currency, see the Federal Reserve Board of San Francisco's Economic Letter dated January 29, 1999.

If the latest round of boom and bust (this time in housing and CDO issuance) hasn't shown the folly of the Fed's attempts to steer "short-term economic growth," what ever will?

For a graphic view of the CDO-issuing explosion that accompanied the Greenspan Fed's lowering of rates to 1% for thirteen months between 2003 and 2004, see this previous post.

One perspective we have arrived at through many decades of observing this problem is that the positive aspects of capitalism which tend to work towards greater productivity and lower prices (as businesses compete with one another to add greater value to their customers) can offset the inflationary mistakes of the Fed. In heavily-regulated environments (such as those that characterized the 1970s), these positive aspects of capitalism are hindered.

These are issues that all investors should carefully consider and understand.

For later posts on this same subject, see also:

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