Thursday, October 8, 2009

The Wall Street Journal: How the Fed can avoid another bubble

Central Bank to monitor the prices of assets, and quickly raise interest rates when decided that the time has come

Ben Bernanke and the Fed are facing a very difficult test in the coming years. Among them:

• Resistance to pressure of monetization of deficits, which eventually could lead to high inflation.
• Identify strategies for ending the massive monetary mitigation of last year.
• Support the independence of the Fed, which rose into question by direct or indirect rescue of financial institutions and the attempts of Congress to control the central bank.
• Properly pricing and risks of asset market bubbles under the Taylor rule, the basic guidelines used by central banks in setting interest rates.
• More effective monitoring and supervision of the financial system, in particular, as a regulator of "systemic risk".

The first two items are closely related. In order to prevent a sustained monetization of deficits that will lead to inflation, the Fed should designate the exit strategies of their non-traditional monetary incentives that were implemented since the end of 2008. If fiscal and monetary stimulus will be removed too early, there is the risk of deflation. If they are removed too late, we can finally get in the face of fiscal crisis and an inflationary recession or stagflation.

Fed does not control fiscal policy. But in order not to fall into a trap, when fiscal policy will force Fed to monetize the deficits in order to prevent the rise in the yield debt securities, the Fed must first declare that he would no longer buy Treasury securities.

With regard to the collapse of monetary easing, the Fed should draw conclusions from the fateful errors made after the 2001 recession. Then the central bank lowered interest rates too much and kept it low for too long. It also increases very slowly, there are signs of stabilization - a slight increase of 0,25% from summer 2004 to summer 2006, when it reached 5.25%. Normalization has taken two full years. This was a period of slow normalization, during which the housing, mortgage and credit bubbles are out of control. Learned a lesson: Going back to normal catch, do it quickly, or get ready for another dangerous bubble.

Of course, easier said than done. From 2002 to 2006 the Fed was moving slowly, due to the fact that recovery was lifeless, and because of the significant deflationary pressures. Now more severe recession: unemployment at 9.8%, and is expected to exceed 10%, and we are experiencing a real deflation. At the same time, the drive does not turn off support too quickly to be stronger, and with it the risk of another bubble and more. In fact, the sharp rise in share prices and commodity areas, and narrowing of credit spreads since March, partly due to the flow of global liquidity has spurred the assets and has already created inflation in assets.

In the conflict between economic growth and financial stability requires that monetary policy has remained free and independent, and it is critical that the observers and regulators of the banking sector acted more aggressively to prevent the development of the next bubble. In this case, they should quickly implement the reforms mentioned by the G20 - including a new bankruptcy regime for financial institutions deemed "too big to fall", a serious approach to the restriction of "systemic risk" and acceptable rules of reward and compensation for bankers and traders.

It will be difficult to define new concepts of system of regulation and the concept of "too big to fall". There is a very high risk that doing so, we will give implicit guarantee of large and complex financial institutions. There is also a long-term risk that the steps taken by Congress and regulators will distort the financial markets. Western financial institutions is currently very much dependent on support from the states, and some governments drove the rules and regulation for the maintenance of large financial institutions, which are now partly bought with taxpayers' money. In the future the government may demand from local financial institutions to increase lending in their own country, which will reduce their international operations. Creating a system of effective financial regulation - at the same time resisting the impulse to give benefits to local institutions - will be a real challenge for most countries, including the United States.

Eventually, when the federal funds rate will be at a normal level, to establish financial stability, will also require the inclusion of asset prices when deciding on monetary policy.

Fed's involvement in quasi-fiscal operations creates other difficulties. While the Fed is involved in maintaining financial stability and to prevent subsequent episodes of systemic risk, it would be difficult to exclude the feeling that the Fed - a lender of last resort for firms that are "too big to fall". Until now, a Pandora's box is open.

By preventing future distortion is a regime where "too big to fall" institutions will be more demanding in terms of equity capital: a bigger buffer of liquidity, lower leverage and lower involvement in risky and illiquid investments, if they deposit banks . They should be monitored by international observers and to be able to be closed in an orderly fashion in case of signs of bankruptcy.

The Fed is currently resisting pressure from the Treasury to revise its own device, without regard to the fact that it may deprive Fed independence. Control Structures of New York and other regional reserve banks allowed to be effectively controlled by major financial institutions last year, so that this situation should be reconsidered. While the intervention of Congress in the jurisdiction of the Fed - is a danger of his recent quasi-fiscal activity leads to review these rules.

Fed needs a large regulatory capacity. At the Fed has the power to regulate mortgage markets, but can not use that power to reduce the difference between the situation on Wall Street and the market where there is no interference. The regulation of mortgage markets requires a careful balance: short-term policy of containment to prevent further credit crisis, combined with the medium-term counter-cyclical policies to prevent the development of bubbles in the credit markets and assets.

Establishing financial stability - in addition to price stability and sustaining growth - is the direct role of the central bank. In pursuing this goal through the avoidance of distortions to the "too big to fall" of financial institutions and prevent bubbles in the coming years will certainly be one of the most difficult test to be faced by the Fed.

Authors: M r. Bremmer (Bremmer), president of Eurasia Group, co-author of "Fat Tail: The Power of Political Knowledge for strategic investment» ( "The Fat Tail: The Power of Political Knowledge for Strategic Investing", Oxford University Press, 2009). M-p. Roubini (Roubini) Professor of Economics at Stern School of Business at New York University and head of RGE Monitor.

The Wall Street Journal, October 5

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