Wednesday, March 28, 2007

Faith in the Fed

It is remarkable just how strong faith in the Fed is. The belief that the Fed will work its magic under all economic circumstances is so ingrained in investors that it borders on the mythical. This is a mistake.

This is not to say that central bankers haven’t become more proficient in managing the world’s capital resources. They have. However, the fact that all economies function within the framework of a global economy raises the stakes considerably. And makes managing such an entity that much more difficult. Consider the issue of coordination.

When one considers the fact that there is not a world central banker, coordination between domestically oriented (and politically influenced) central banks cannot falter. Yet, central bankers are near autonomous entities*. They are subjected to the political dynamics of their respective countries. Moreover, there are diverse interests and needs within each economy that influence domestic monetary policy. Lastly, their individual missions are not exactly identical to each other. For example, the Fed’s dual mission of growth and stability is not the mandate of most central bankers. And all this doesn’t take into account the core of their capabilities – monetary policy.

There is a danger in a near blind faith in their powers. Forgotten is the fact that central bankers are limited in the tools at their disposal. The Keynesian levers of demand management have been replaced by a strong belief in market fundamentalism, globalization, and the capital management skills of the world’s central bankers. How long this trio can maintain global growth and stability remains to be seen.

Investment Strategy Implications

It is worth remembering that there was a time when economic downturns, absent fiscal deficit spending policies, revealed a key weakness in a central banker’s monetary powers. It was during the first globalization and it was called “pushing on a string”.

Faith in the Fed may be high among market participants. But it should not be a blind faith.

We know that the market hates negative surprises. With faith and expectations in the Fed so high (and risk premiums still so low), just how strong should faith in the Fed be?

A little something to think about as Bernanke speaks today.

*I say near autonomous as the power of persuasion from the Fed to other central bankers is considerable (Bank of Japan, for example), although not absolute. Nor permanent.

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