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Thursday, November 02, 2006 12:52 PM

Confessions by the Fed

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If ever a case could be made to abolish the Fed and to let the market set interest rates, that case was made today. Ironically enough the case against the Fed was made by Richard W. Fisher, a current Fed Governor. Please consider the following speech:

Confessions of a Data Dependent
Fisher's remarks before the New York Association for Business Economics
New York Nov. 2, 2006

A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent "lower boundary." At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth.
If anyone ever wondered how or why the Fed kept blowing bigger bubble after bigger bubble the confession by Fisher above should explain it all. The Fed was too slow to halt the massive expansion of credit leading up to the dotcom bust, then overreacted on the way down which fueled the biggest housing bubble and credit lending bubbles the world has ever seen. In simple terms the Fed is always chasing its own tail.

Now Fisher seems worried that it is "complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth."

Economic Zugzwang

Unfortunately "Complicating" does not remotely begin to describe the problem Bernanke faces. Readers may wish to ponder The Red Queen Race written on back on February 22nd.
In Lewis Carroll's Through the Looking-Glass there is an incident involving the Red Queen, a representation of a Queen in chess, and Alice constantly running but remaining in the same spot. The scene is often referred to as The Red Queen's Race.

"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else -- if you ran very fast for a long time, as we've been doing."

"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"

I picture Ben Bernanke as the new Red Queen.
He is now trapped in Zugzwang.

Definition: A German term for the obligation to move. All legal moves lead to a worsening of the position.

Click on the above link for multiple chess possibilities. Here is one example (taking poetic license) as the position shows a red king not a queen.

For non-chess fans who might not fully understand the above position: no matter which way Bernanke moves, white will next capture the red pawn, and march the remaining white pawn to victory. The red king can not capture the white pawn or move one square forward since either would put the king in "check" (subject to capture by the opposing king or pawn).

In economic terms, there is no magic mirror.
Bernanke is trapped in "Wonderland" but unlike Alice has no way out.

Ludwig von Mises understands the endgame brought on by reckless expansion of credit:
"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved."

The sooner the Fed (and this administration) understands that last paragraph, the better off we will all be. If they fight this to the end (which they will likely do) I have two predictions: It won't do them any good (because it will not create any jobs and there is no pool of real funding), and the price of gold will soar.

Mike Shedlock / Mish

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