I think it's very simple.

They know something bad is going to happen. It could be a deflationary recession, it could be out of control inflation. In a world awash in liquidity and debt, in which the US Fed has limited effective control over the quantity of money and the quality of claims, either possibility is plausible.

The Fed doesn't want to be blamed. Feds are historically blamed first for pushing interest rates too high (causing a deflationary recession), and second for letting inflation get out of hand. So, the Fed's first priority is not being blamed for acting too aggressively and causing a recession. They can avoid blame by pausing the rate hike cycle, if it seems decent to do so, or by moving 25 bp per meeting, if inflation numbers run high. That "measured pace" is now a kind of default, not a blame magnet, and anyway, it's a Greenspan Fed strategy, so if contiguous 25 bp moves precede a recession, most of the blame goes to Bernanke's predecessor. But the Fed also doesn't want to be blamed for failing at its core mission of keeping inflation under control. So, in "jaw-jaw" mode — speeches, informal comments, etc. — Fed officials come off as hawkish, hoping to maintain their credibility as inflation fighters, and thereby reduce self-fulfilling expectations of increased inflation.

This is a fairly optimal strategy for avoiding blame. If a recession hits, blaming the Fed for being too aggressive will have limited traction. After all, the Fed only continued its predecessors policy of gently tightening, and only when inflation numbers clearly forced continued tightening. Blaming the Fed because Bernanke talked about inflation numbers exceeding his comfort levels in some speech is not going to take. The formal record will be one of very measured interest rate rises, and very moderate statements and minutes. If there's a recession, it won't be the Fed's fault. If inflation continues to pick-up, the Fed can try to maintain its credibility by talking tough and continuing the 25 bp hikes. If the Fed really is "behind the curve" on inflation, and prices accelerate, eventually they might be blamed. But that involves incremental and subtle attributions of blame. They can always, actually "shock the market", if things get out of hand and the blame for inflationary pressires gets palpable. But much better to threaten to do something radical (deniably, through third parties and rumors) than to take the risk of actually doing something, until something absolutely must be done, and the risk of serious blame can no longer be avoided.

I do think some kind of bad economic period is inevitable, though whether it looks like recession or stagflation or just modest inflation and sluggish real growth is uncertain. I'm not sure that I blame the Fed for avoiding blame. But I do blame the Greenspan Fed, and current administration, and the ossification of economic ideas into stale ideologies over a longer period of time, for getting the US economy into an obvious, big mess, while the best and brightest debated whether a garbage dump wasn't the optimal outcome if something resembling a market happened to produce it.

Steve Randy Waldman — Friday June 30, 2006 at 12:29pm permalink
Steve, thought u might like this piece.

Government Debt: Termites in the House
By Bud Conrad

Recently I had the pleasure of having lunch with the Comptroller General of the United States, David M. Walker. He heads up the U.S. Government Accountability Office (GAO), the government's internal watchdog. As he was about to give a talk on out-of-control government deficits, he had in his briefcase a chart on the size of the government's obligations over time. Our discussion about those obligations over lunch was followed by an email exchange, and Walker kindly helped me source additional GAO data, all of which allowed me to confirm my analysis of the budget with projections from the Congressional Budget Office (CBO).

I have also met with Douglas Holtz-Eakin, head of CBO, who can competently recite the situation of six different budget projections without notes. The combined scenarios of the GAO and CBO provided me with the basis to create the following projection of the U.S. budget:

A clear picture emerges of a government completely out of control. The blue line is the history of the U.S. Federal Government debt. The green line shows the path we are now on, with debt soaring to impossible levels against projected GDP. Importantly, the source isn't some crazy hand-waving blogger: these are the government's own projections—and we all know they have every incentive to accent the positive. If this is the best they can do at this point, then you know things are not just bad, they are calamitous.

This glimpse at the future clearly shows that the debt of the U.S. will, in the foreseeable future, go from being a troubling yet manageable fraction of the economy to being several times the size of economy. That can't happen without serious repercussions.

The government will be spending money they don't have, which means creating more of it out of thin air and diluting the value of all the dollars that came before. It doesn't take a Harvard MBA to know that the kind of deficits projected above guarantee a persistently weak dollar, higher inflation and higher interest rates going forward.

You may be right to criticize this analysis as only one of many scenarios being developed all the time and that there are other assumptions that lead to other estimates, and you would be right.

But I've looked at the assumptions, as has David Walker, and it is more likely that the assumptions have underestimated how serious the situation could become, maybe by a significant margin. For example, in the projections above, the interest rate paid by the government stays flat. Interest rates fell for 23 years and have only just recently bounced off of 45-year lows. The odds of interest rates staying at these low levels for decades into the future are, in my opinion, nil. I have analyzed the scenario of the impact of higher interest rates. The problem can get out of hand because it feeds on itself: higher interest rates lead to higher interest on debt, which leads to higher debt, which leads to greater loss in confidence in the dollar, which leads to higher interest rates… and the loop makes itself worse.

The Blame

Who is responsible for this sin of profligate spending? You could start by pointing a finger at the House of Representatives as they are constitutionally charged with holding the purse strings of the U.S. government. They voted for the spending and programs we are now saddled with, they pass tax programs, and vote in the big supplemental bills that fund the wars.

Entrusted with allocating the biggest sums of funding in the world, they clamor for more and, in the process, act like termites chewing away at the fiscal underpinnings of the economy, assuring the future bankruptcy of the nation. And it is not just the modern politicos that are responsible, but a failure to pursue sound monetary policies that extends back decades. Why do they do it? That answer is easy and reflective of human nature… they do it to curry favor with their constituents in order to get reelected.

Which further points the finger at us, the American public, who instead of voting the bums out for wasting our money and handing a legacy of debt to our grandchildren's grandchildren, happily pocket the pork belly doled out and reward the most prolific spenders with our votes.

The bottom line is that debt and deficits are baked into the cake, exacerbated by the demographics of retiring baby boomers and a government that not only shows no intention of slowing its spending, but quite the opposite. In fact, like a penniless smoker breaking a child's piggy bank to buy a pack, the debt-addicted government has already spent the supposed “Trust Funds” of Social Security and Medicare.

The government is closer to bankruptcy than anyone who has not studied the situation can guess. You will hear government apologists claim that the government can't go bankrupt because they are the government, and along with a complicit Federal Reserve, they can meet any debt obligation because they have the printing press. That is precisely the problem. They can print any amount of money they want. That has been theoretically possible since we went off the gold standard in 1971.

It is this loss of any constraint on government spending that has let the genie out of the bottle. The track is now laid. The long-term future of the dollar is not in question. And to the extent that it is the basis of all other currencies, the reserve currency of the world's central banks, all currencies are doomed.
7.2.2006 1:31am
Steve Randy Waldman (mail) (www):
groucho -- yeah, i do like it. until we start growing the tradables sector again and stop taking on external debt... well, bad things. sometimes an ability to borrow is like the cushion of air that delays the pain while you're jumping off the cliff. the US has every incentive to print its way its of debt, and probably will. It's our currency, your problem, after all. but we only get to do that once. when the reckless creditors stop crediting, maybe economic signals will bite and nudge the US economy from its comfortable unreason.

thanks for the pointer!
7.2.2006 10:51pm
"the ossification of economic ideas into stale ideologies over a longer period of time, for getting the US economy into an obvious, big mess, while the best and brightest debated whether a garbage dump wasn't the optimal outcome if something resembling a market happened to produce it."

Steve, do you have any new ideas about the evolution of the western capitalist system?

In my way of thinking, politics almost always trumps economic activity. eg..geo-politics vs international trade and macro-economics....national politics vs domestic economic issues...etc..

After reading Woodwards "Maestro", I came to the conclusion that Greenspan is really a political entity. FOMC meeting outcomes were always pre-determined. The reality is they were run more like a dictatorship(I imagine similar to how Saddam Hussein would run his meetings...you don't get any "NOs")

I do believe Greenspan has his own agenda and was trying to drive the american system towards his goals. As far as I can see, the current system cannot continue for an indefinite amt of time going forward. If this is so, do you believe that this is a "planned" failure or just stupidity?
7.6.2006 11:07pm
"Continued strong demand for dollar assets will be critical to keeping that unwinding smooth and not disruptive. The Federal Reserve can contribute by being sure the public remains confident that the purchasing power of their dollar assets will not erode unexpectedly. As long as inflation expectations remain contained, relatively faster growth of the prices of imported goods for a time would be associated with only a temporary bulge in inflation and would result in a needed change in relative prices. The lesson from the 1970s, however, is that an unchecked or permanent increase in inflation would only feed back adversely on demand for dollars. Such an unmooring of the anchor of price stability could only elevate the odds on abrupt changes in interest rates and asset prices, instability in the U.S. economy, and disorder in global adjustments."

Steve, pulled this out of Kohn's speech in London(july 6)

Seems to say that the FED expects to hold interest rates UP as the treasury(paulson) works on the asian/us exchange rate.
I can't make up my mind of what the FED will do next year in the downturn. I think the best guess now is that they will hold them at a moderately high level(no ZIRP)
7.7.2006 11:17am
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