–Fed Operating In Fisc/Regulatory Labyrinth As Seeks Growth,Price Stab

By Steven K. Beckner

(MNI) – Once again, Federal Reserve policymakers face a
government-manufactured mess, not to say crisis, going into a Federal
Open Market Committee meeting, and once again, the Fed is under pressure
to come to the rescue of failed fiscal and regulatory policies.

Stocks are falling further as markets reopen following a Friday
night downgrade of U.S. debt that was greeted with feigned shock at the
U.S. Treasury. Americans’ stock portfolios have already “corrected” well
in excess of 10% with more to come, and a full-fledged bear market
threatens as distrust of paper assets causes a wave of risk
aversion/revulsion.

Heavy household wealth losses and the possibility of rising market
interest rates puts an already scant economic recovery at risk. And
that’s not even taking repercussions from the European debt crisis into
consideration.

What can or should the FOMC do?

Chairman Ben Bernanke, joining with fellow Group of Seven central
bankers and finance ministers, has already committed the Fed to certain
types of actions Sunday night following an emergency conference call.

“In the face of renewed strains on financial markets, we, the
Finance Ministers and Central Bank Governors of the G-7, affirm our
commitment to take all necessary measures to support financial stability
and growth in a spirit of close cooperation and confidence,” the G-7
said in a joint statement. “We are committed to taking coordinated
action where needed, to ensuring liquidity, and to supporting financial
market functioning, financial stability and economic growth.”

The G-7 policymakers further “reaffirmed our shared interest in a
strong and stable international financial system, and our support for
market-determined exchange rates. Excess volatility and disorderly
movements in exchange rates have adverse implications for economic and
financial stability. We will consult closely in regard to actions in
exchange markets and will cooperate as appropriate.”

“We will remain in close contact throughout the coming weeks and
cooperate as appropriate, ready to take action to ensure stability and
liquidity in financial markets,” they added.

But beyond standing ready to provide liquidity to stabilize markets
what will the FOMC do? What should it do?

Earlier, the European Central Bank set one example — overcoming
strong opposition by some euro zone officials to begin buying the shaky
government bonds of Italy and Spain in what amounts to a monetization of
those countries’ debt.

Some think the FOMC must follow suit and resume large-scale
purchases of U.S. Treasury securities and perhaps agency debt — a third
round of “quantitative easing” or “QE3.” But that would be problematic.

When the $600 billion “QE2″ was launched last November a plausible
case that inflation was verging too close to deflation could be made,
although some challenged that assumption. Now, inflation is rising, not
falling, and the U.S. dollar is more vulnerable.

True, the recovery seems to be in danger of stalling, and
unemployment is very high even after the small dip it took in July with
the help of another large exodus of discouraged workers from the labor
force.

But would more Q.E. on top of the $2.3 trillion already done help?
Has the massive monetary and fiscal stimulus already undertaken in the
past few years as part of a grand Keynesian experiment helped? Some Fed
officials contend that the economy would be in worse shape without it,
but the verdict is by no means unanimous.

Most importantly, a “QE3″ would look even more transparently like a
Fed effort to help a downgraded U.S. Treasury finance deficit spending
by resisting any upward pressure on bond yields that might emerge. In
other words, it would look more like domestic debt monetization — like
“printing money,” a phrase Bernanke has actually used on more than one
occasion in recent years to describe what the Fed was doing.

Alternatively, the FOMC could avail itself of one of the other
options Bernanke mentioned in his Monetary Policy Report to Congress
last month. It could cut the already bare-bones rate of interest it pays
on excess reserves. Former Fed Chairman Alan Blinder has even suggested
that the FOMC go to a negative interest policy, forcing banks to pay for
holding reserves, in an effort to spur more lending.

Or, more likely, it could tinker with its “forward guidance” pledge
to hold the federal funds rate near zero “for an extended period.” It
could be more precise about just how long an “extended period” it
envisions.

The FOMC could also play with the yield curve, shifting the average
maturity of its securities holdings to the longer end to further reduce
already very low long-term rates.

But the FOMC has to ask whether such measures would be credible or
effective — two words the S&P used in marking down U.S. debt.

Explaining its much-anticipated downgrade of U.S. debt from
triple-A to double-A-plus, S&P said that while the recently enacted debt
deal had removed any immediate perceived default threat, “the political
brinksmanship of recent months” showed U.S. policymaking “becoming less
stable, less effective and less predictable.”

When all the issues are considered, there is a strong case for the
FOMC resisting the temptation to “do something, anything” There is a
case for simply maintaining an already very accommodative credit stance,
standing ready to play its lender of last resort role to the hilt but
otherwise avoiding desperate, panicky-looking measures that might
further damage its credibility and undermine the dollar, of which
ultimately it is chief custodian.

But it is not clear that the FOMC will be content to exercise such
restraint.

A vocal minority of FOMC members argue that the Fed has reached the
limits of what it can reasonably accomplish.

As Dallas Federal Reserve Bank President Richard Fisher said back
in January, “There is only so much monetary policy can do now. The ball
is in the other court — the fiscal court.”

Referring to all of the money the Fed has already injected into the
economy, Fisher said, “The gas tanks are pretty full.” Now, “it’s up to
the fiscal and regulatory authorities.” If fiscal and regulatory
steps are taken to improve the business climate there “will be better
income because people will be employed.”

At another dark time for the United States in the early 1980s,
decisive action was taken that not only brought the country out of a
stagflationary malaise but laid the groundwork for a long, job-creating
expansion.

The United States was suffering from both double-digit inflation
and double-digit unemployment. The dollar was nosediving.

Under the leadership of President Ronald Reagan and then-Fed
Chairman Paul Volcker, a Democrat, a determined effort was made to lift
the heavy burden of government on the private economy and to reestablish
sound money policies.

Working with a Democratic Congress, Reagan achieved a combination
of dramatic spending and tax cuts. And Reagan backed Volcker as he wrung
inflation out of the economy and restored respect to the dollar, even
though many in his party howled about the recession which Volcker’s
policies perpetuated for a time.

Today, the landscape is very different.

What are claimed to be “substantial” spending cuts have been deemed
inadequate not just by the embattled S&P but by millions of investors.
And one political party thinks it would be a good idea to raise taxes,
even though the economy is teetering on the edge of falling back into
recession.

Stark ideological battle lines have been drawn. Those who think the
federal government has “a spending problem, not a revenue problem” after
watching spending double under Presidents Bush and Obama, and who want
to reduce the rate of growth in spending more aggressively were likened
to “terrorists” and “hostage takers” in a meeting of members of
Congress led by no less than the vice president of the United States
recently.

America’s debt was downgraded and further downgrades threatened
because the debt deal which President Obama signed last Tuesday would
reduce deficit spending by only $2.1 to $2.4 trillion — far short of
the $4 trillion needed — and then only if a special committee can agree
on “cuts” beyond an initial $900 billion.

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** Market News International **

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