----- Original Message ----- From: "Eubulides" <paraconsistent at comcast.net>
12] complete rethink and re-authorization of the Federal Reserve System
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By sheer coincidence:
full piece @: http://www.morganstanley.com/GEFdata/digests/20040217-tue.html Global: Central Banking Discredited
Stephen Roach (New York)
They are yesterday's heroes. Central banks ruled the world during some 22 years of disinflation. But like most champions, they have overstayed their welcome. The world's major central banks - the Federal Reserve, the Bank of Japan, and the European Central Bank - have squandered the capital they built up in the long and arduous war against inflation. And now, with their policy arsenals dangerously depleted, they are woefully ill-equipped to cope with the ever-daunting complexities of a post-inflation era. Bondholders beware: Your once-proud defenders have met their match. I fear modern-day central banking is on the brink of systemic failure.
[snip]
Long gone are the days when the monetary authority could afford the luxury of focusing on "closed" models of country-specific economic performance. Globalization - and the increasingly integrated and fast-moving flows of goods, services, and financial capital - demands "open" models of policy formulation. On that score, the BOJ is being pushed well out of its comfort zone to engage in the functional equivalent of unlimited currency intervention. Nor are the impacts of such policies without their own unintended consequences: To the extent currency intervention results in massive purchases of US Treasuries, that has the effect of reinforcing the Fed's efforts to suppress American interest rates. That could well further exacerbate imbalances in the US economy and in the US-centric global economy.
The Fed, for its part, has gone out of its way to assure market participants that it has learned the lessons from the Japanese experience (see Alan Ahearne et al., Preventing Deflation: Lessons from Japan's Experience in the 1990s, Federal Reserve International Financial Discussion Paper No. 729, June 2002). That remains to be seen, in my view. The US central bank has all but refused to modify its policy framework to cope with extreme fluctuations in asset markets. Chairman Alan Greenspan has led the debate, arguing instead that the monetary authority had best be prepared to deal with post-bubble damage containment rather than take preemptive actions to stave off speculative excesses (see Greenspan's recent speech, Risk and Uncertainty in Monetary Policy, remarks presented at the meetings of the American Economic Association, San Diego, California, January 3, 2004).
The Fed's approach in dealing with asset bubbles suffers from three serious shortcomings, in my view:
* First, it may only be a "one-bubble" success story. In a low inflation climate, aggressive post-bubble easing can take the policy rate down to exceedingly low levels. Witness today's 1% federal funds rate - dangerously close to the zero nominal interest rate boundary. If the Fed is unable or unwilling to lift rates for any reason, then it will be lacking in the ammunition required to deal with subsequent post-bubble shakeouts or other deflationary shocks.
* Second, it creates a moral hazard dilemma. The fear of lingering post-bubble deflationary perils - a classic by-product of an asset bubble - can lock a central bank into a protracted monetary accommodation. It doesn't take investors and speculators long to figure that out - especially with the Fed now back to its old tricks of wordsmanship (i.e., splitting hairs between "considerable period" and "patient" insofar as the duration of monetary accommodation is concerned). Persistently low nominal interest rates are a breeding ground for subsequent asset bubbles. Recent activity in property, bond, high-yield debt, credit markets - to say nothing of renewed froth in equity markets - hardly makes that idle conjecture.
* Third, it perpetuates the risks of an asset-driven economy. The lingering asymmetrical biases of post-bubble monetary policy accommodation and the surging asset markets such policies support, keep the US economy heavily dependent on wealth effects. That exacerbates the imbalances of reduced saving and increased indebtedness. Should the economy suffer from a shortfall of income generation - precisely the case with America's jobless recovery - an asset-driven economy may be all the more vulnerable to the inevitable back-up in real interest rates that normally afflicts an unbalanced economy.
In other words, the jury is still out on America's Federal Reserve. From where I sit, the evidence is not very comforting. Yet "Fed-spin" has shifted into high gear. The US monetary authority has gone overboard to convince financial markets it has learned the painful lessons of Japan. In the end, however, it may well be that the Fed and the BOJ have all too much in common.
[snip]
A systemic failure of monetary policy also raises the risk of a political backlash that could jeopardize the hard-won independence of central banking. In my view, politicians will not sit by idly if central banks repeatedly mismanage their economic mandates. A politicization of central banking cannot be ruled out if that turns out to be the case. Anti-inflation discipline would probably be the first thing to go in such a new regime. And that would be the last thing an over-bought bond market needs at the end of nearly a 22-year secular rally. Ironically, there are those now bemoaning the extinction of the bond-market vigilante (see "The Last Vigilante," by PIMCO's Bill Gross, February 2004). The downfall of central banking may yet give those grizzled old warriors a new lease on life.