The Fed Chairman addresses how to deal with inflation

There are two major levers for economies around the world.  The first is fiscal policy.  That is, the collection of budgetary, taxation and legal choices made by the legislatures of the world’s nations.  The second is monetary policy.  That is, the interest rate and money supply choices made by the central banks of the world.  Within that framework, I would argue that this most recent recession had two primary structural causes, one fiscal and the other monetary.

The first was the choice made by a business-beholden Congress to repeal many of the Great Depression-era laws that economically protected the U.S. for nearly three generations.  This is categorized as a fiscal policy mistake as the U.S. Congress is directly in control of budgetary, taxation and legal choices.

The second primary cause was the Federal Reserve’s choice after the recession of 2001 to leave interest rates incredibly low for almost a decade.  Any time you underprice an asset, in this case money itself, then that asset has excess demand and overuse.  In other words, the air in the economic bubble was crazy low interest rates.  This mistake is a monetary policy snafu as the Fed sets interest rate policy for the United States.  Not only that, but it is the World’s de facto Central Bank.

It’s only natural that many investors, myself included, are concerned about ensuring these two causes do not repeat themselves.  While the renewing of protective legislation seems stalled out in Congress, the interest rate debate is raging on.  To that effect, Federal Reserve Chairman, Ben Bernanke, testified before Congress today to discuss how the Fed plans on dealing with interest rates once the U.S. economy is on sounder footing.

Banks often park their excess cash reserves at the Federal Reserve.  They not only do this to ensure that they can earn an interest rate on the reserves, but also to ensure the safety and liquidity of their principal.  The Federal Reserve has been paying very, very low rates on these reserves.  In effect that acts as an economic stimulus.  The reason is that banks like to earn high risk-adjusted returns on their investments, just like all of us.  So when the Fed pays a very low rate on reserves then banks have a greater incentive to find an alternative investment that pays a higher return; say mortgages, for example.  Another example, would be lending to other financial institutions who are short in meeting reserve requirements.  There are many such options.  But if the Fed is concerned about inflation then it wants to take money out of the U.S. economy.  One way of doing this is to raise the interest rates it pays to banks.  In so doing, then the banks have an incentive to park more reserves at the Federal Reserve, thus taking excess funds out of the economy.

While this sounds very dry, this is actually a radical departure in how the Federal Reserve implements monetary policy.  Traditionally the Fed changed the “Fed Funds” interest rate.  This is the rate that banks pay each other when they borrow from another bank.  But during the recession banks stopped trusting one another.  Thus, when a bank that needed to borrow money to meet minimum reserve requirements called a bank with excess reserves, more often than not, the bank in the more favorable position declined to lend money.  Ouch!  So the Fed stepped in as the lender of last resort.  It is for this reason that the Fed has so dramatically changed how it implements monetary policy.

While Ben Bernanke discussed how he would deal with inflation, he did not discuss when he would deal with inflation.  Nor did he state specific criteria to be looking for.  This is disappointing.  However, by not addressing the issue we can assume that Bernanke does not feel that the U.S. economy is on a firm enough footing right now to justify a raise in interest rates.  So the inflation fears remain.  And, as an investor, the last thing I want to be dealing with right now is another fear hanging over the market.  Ugh!

Jason