With the Fed making its interest rate decision Wednesday 7-31-2013, and the ECB and BOE making their interest rate decisions the very next day, I wanted to compare some of the main differences between the central banks. They differ in more ways that most people may think. The structure, politics, objectives, mechanisms for achieving those objectives are all very different. While the ECB preaches PRICE STABILITY over everything else, the Fed has left fingerprints of artificial manipulation all over the stock, bond, commodity, and housing markets.
It’s obvious that what the Fed is doing to stocks in not a shining example of price stability. When Bernanke made his June statement, found here, we saw a positive picture from the Fed. “Economic activity has been expanding…Labor market conditions have shown further improvement…Household spending and business fixed investment advanced, and the housing sector has strengthened further”-The Fed What happened after this good news? The stock market sold off hard. It was like taking stimulants away from a kid with ADD. The markets went into withdrawal. Prices are not higher on real economic performance. They’re not higher because of increased efficiency, improved technology, or anything that should legitimately improve the price of a stock.
Here’s what the Fed does well…they have a kick ass PR team. They measure every single word as if it would be scrutinized by millions of people. It wasn’t always this way. Volker used to just come out of no where with big interest rate changes, and very few ever cared about what had to say. The Fed Chairman’s statement following an interest rate or policy decision has become a mainstay in today’s financial media. After Volker, Greenspan came in, and what can I say? The man loves to hear himself speak. According to Greenspan lore, he takes an hour long bath every morning. Anyone who takes a bath every day has a lot of time to think about what he’s going to say. He was very careful with his words, and knew people were hanging on every word. Bernanke is much more of an academic than his predecessors, not enjoying the spotlight but performing his job with as much scientific precision as he’s capable of. He views the statement as a tool for creating transparency and stability. He wants to plan ahead, let everyone know the plan, and then do his best not to screw up the wording. He’s pretty good at it too.
Here’s what I don’t like about the Fed. There is no control on spending. The dual mandate… (I hate that word by the way. Why don’t they just say objective?) The dual mandate of low unemployment and moderate inflation were a great idea, but now we realize that there are no controls over Fed tools. They can spend as much money as they want with no repercussions. It seems like they are achieving their goals of lowering unemployment while keeping inflation under control. Stocks are up, unemployment is coming down, inflation measures like the PCE CPI and PPI are under control, and the housing market is making a big rebound.
Despite these positive signs, what is the cost? Does monetary policy have a long term effect on unemployment or economic growth? We’re flooding the market with easy money, but is that the reason we are recovering? Our Debt to GDP ratio is not in a healthy state. Quantitative Easing isn’t bringing our debt down, and if it is moving GDP, it isn’t much. It’s definately not moving real GDP over the long term according to most economists. We need to solve this problem with one of two solutions. There should be a third mandate of stable debt/gdp or a simplified objective like the ECB’s price stability.
Take a look at the ECB’s Objective:
To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1).
“Without prejudice to the objective of price stability”, the Eurosystem shall also “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”. These include inter alia “full employment” and “balanced economic growth”.
The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.
This policy is so clean. It’s really simple. Now take a look at the benefits the ECB claims are achieved through the price stability.
- improving the transparency of the price mechanism. Under price stability people can recognise changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well-informed consumption and investment decisions and to allocate resources more efficiently;
- reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest;
- avoiding unproductive activities to hedge against the negative impact of inflation or deflation;
- reducing distortions of inflation or deflation, which can exacerbate the distortionary impact on economic behaviour of tax and social security systems;
- preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation;
- and contributing to financial stability.
The first benefit is transparency. The dual mandate used by the Fed gives them the ability to go one way or the other depending on which mandate they are more worried about. This leaves us guessing what they’re going to do, and it requires a lengthy statement for true transparency. They ECB statement is much shorter, and to the point. “At today’s meeting the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.50%, 1.00% and 0.00% respectively.” (Aug 1, 2013) That’s pretty straight forward. There is little room for misinterpretation.
The other benefit that really grabs my attention is that price stability [is used for] “preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation.” That is so drastically different than the Fed, it’s not even funny. To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.-The Fed
This $40 billion per month of mortgage backed securities bought is causing a massive redistribution of wealth. If you are not a homeowner, you’re kind of getting screwed right now. The sad part is that young homeowners were one of the largest segments to sell out of their homes when the market tanked in 2009, and the smallest segment to buy in since then. Between 2006 and 2011, the number of people age 25 to 34 who owned homes fell 7 percentage points. The next age group, 35 to 44, saw their home-ownership rate decline 6.3 percentage points. In contrast, the ownership rate for those ages 55 to 59 fell 3.3 percentage points, and the rate for Americans 60 to 64 fell 1.9 percentage points. The national average decline was 2.7 percentage points.-http://realestate.msn.com/blogs/post–housing-recovery-leaves-young-people-behind
Our national debt will have to be repaid by generations to come. It’s on our executive and legislative branches of government to control spending. Of coarse our spending problems go way beyond the QE with healthcare defense and entitlements, but $85 billion a month? Is that really necessary? The Fed is only acting under guidelines and government mandates laid out for them by Federal Reserve Act of 1913. It was amended in 1930 to create the FOMC. In the 70s, it was amended to require the Board and the FOMC “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”-section 2A of the act.
It’s been fourty three years since the last amendment. We’ve learned a lot since then. We’ve learned a lot since the housing crisis and the credit crisis. It’s time to amending the Federal Reserve Act again.
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