2009-10-21

The Fed's Mexican Standoff

Mish Shedlock highlights a Carolyn Baum article in Fed Sponsored Feedback Loops and the Fed Uncertainty Principle Revisited. Here's an excerpt from Baum's article, Bernanke Frets Over Sherlock Holmes’s Next Stop.
If I have this right, we’re waiting for the Fed to do or say something to help us decide whether we should hoard cash (because we expect the dollar to buy more tomorrow if prices are falling) or buy and hoard hard goods (if we expect inflation to diminish the dollar’s purchasing power).

The Fed, in turn, is waiting for us to do something so it can decide what to do: either raise the volume on its anti- inflation rhetoric with talk of exit strategies and price stability; or talk softly to allay fears of premature rate increases to keep market rates from rising.

This is hard enough for your average MBA graduate on Wall Street to understand. And the Fed expects the average Joe on the auto-assembly or unemployment line to have a well-formulated view of inflation expectations?

It’s not that people aren’t rational; they are. It’s that they lack perfect information.
Baum's main point is that the Fed creates inflation. Period. Full stop. The public cannot create inflation because the public doesn't control the money supply. (There are some who believe money creation by the Fed backfills the credit creation by private firms, which widens this debate, but I'll ignore that for now because the Fed can always refuse to print money.)

Baum focuses on the public view of inflation, who have a tenuous at best grasp of inflation and the current inflation rate. I'm more interested in the financial markets view. The smart money is watching the Fed to see if it will inflate or deflate, while the Fed is watching them to see if they hoard dollars or hoard assets. It results in a Mexican standoff with both sides waiting for the other to move.

In any event, I don't see how the Fed can pursue a "sane" policy of inflation with everyone watching, since it would drive up commodity prices and interest rates beyond their "equilibrium" as it created new bubbles, which would then lead to another crash as the Fed tried to tame "inflation expectations", or simply by the higher prices acting as a tax on consumers, as we saw with the oil bubble in 2008.

No comments:

Post a Comment