Politics & Policy

Fed to Basics

Federal Reserve board chairman Ben Bernanke talked tough on inflation during his two-day testimony before Congress this week, but his expressions of doubt about the economy indicated that he thinks it’s still too early to raise interest rates. We hope we’re reading him wrong. The Fed cut rates too precipitously over the past year, and a move in the other direction is long overdue.

Since the Fed commenced its drastic rate-cutting last September, the value of the dollar has plummeted. The Labor Department reported Wednesday that inflation is as bad as it has been in 17 years. The price of commodities — most important, oil — rises apace, spurred on in part by the weakening dollar. But even as Americans pay the price for high inflation, the economy continues to stagnate. Bernanke’s rate-cutting isn’t loosening the credit contraction; it’s just driving up the cost of living.

The problem with Bernanke’s approach is that the credit crunch is not about a lack of liquidity; it’s about a lack of information. The nation’s leading financial institutions have a lot of their assets tied up in mortgage-backed securities of questionable value. To put it bluntly, no one knows what some of this stuff is worth. As long as the giants are grappling with this problem, they’re operating in a state of paralysis that affects thousands of smaller banks; lending has slowed down, making it harder for businesses to grow and create jobs. 

Further rate cuts are not likely to fix this mess — nor is Fed’s latest power-grab likely to prevent the next one. Last week, the Securities Exchange Commission essentially gave the Fed the authority to regulate investment banks. With that authority, however, comes an “implicit guarantee” that the Fed will bail out investment banks that get into trouble, just as it bailed out Bear Stearns last March. Hmm… “implicit guarantee” sounds familiar. Where have we heard those words before?

Indeed, the Fed’s assumption of regulatory authority over the investment-banking sector “will lead to these investment banks becoming little Fannies and Freddies,” according to American Enterprise Institute financial-markets expert Peter J. Wallison. A federal backstop for the investment banks would permit lenders to view them as good credit risks even when they’re not. That’s what allowed Fannie and Freddie to grow so large — and so dangerous.

The country would be much better served if, instead of finding new missions for the Fed, Bernanke focused on its core mission of protecting the currency. A rate hike would bolster the dollar, giving U.S. consumers more purchasing power as they try to ride out the credit crunch. Recent history gives us reason to think it would put downward pressure on oil prices, too.  

In early June, Bernanke gave a series of speeches in which he voiced his commitment to a strong dollar. His remarks prompted a dollar rally, and the price of oil subsequently fell. Those gains were wiped out, however, when Federal Reserve officials failed to raise interest rates at a meeting later that month.

This week, Bernanke assured Congress that he thinks inflation “currently is too high.” Sure enough, the price of oil fell by $11 as the dollar rebounded against the Euro. When Fed officials meet to discuss interest rates in early August, will they improve upon those gains? Or will they give us another disappointing summer re-run?

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