Notes From Underground

Yesterday’s release of the FOMC minutes seriously called to question the potential onset of deflation and it is causing the battle lines to be drawn. There is no question that the FEDERAL RESERVE BOARD is in the throes of a battle between those who remember 1937 and those who are more prone to favor some cleansing of the financial system by bearing the costs of too much debt. Thomas Hoenig, Jeffrey Lacker and others are worried that the FED has stayed too loose for too long and are merely going to recreate the atmosphere that was responsible for the current crisis. Bernanke, Rosengren, Kohn and others are output gap-oriented and remember the pain of stimulus removal before growth has gained traction. This is where we are in real time and the FOMC minutes reflect that the FED CHAIRMAN has and will prevail. Since Bernanke is an academic, he gives open debate a place in his FED–unlike the autocratic Greenspan. But debate is not outcome and while the media gets to fill time and space, the FED’s most recent minutes has illustrated a clear path.

Today, Obama’s three FED nominees appear before the Senate Banking Committee. (We are sure that all three will be confirmed and that this is a mere matter of procedure.) Why is that important? First, Janet Yellen is up for Fed Vice Chairperson, and she is on the record as being most concerned about job creation and that it must be a high priority. In a prepared statement to the confirmation hearing panel Yellen wrote:

“With unemployment still painfully high ,job creation must be a high priorityof monetary policy.”

Yellen has continually warned of “headwinds” to growth in her present role as president of the San Francisco FED. Second to be confirmed is Sarah Bloom Raskin and she too is concerned that too many Americans are unemployed. In her prepared remarks she said:

“… stable prices are only a partial victory when many American households continue to face the perils of unemployment.”

Raskin has served as Maryland’s top bank regulator so that is an expertise that is sorely needed at the FED. The pattern emerging is Obama has selected FED appointees who will lean toward the mandate of job creation and then will meet the mandate of inflation control.

David Blanchflower, the special guest on CNBC’s Squawk Box, discussed the issues of the FOMC minutes and stressed the need for the FED to do all it can to curtail the growing threat of deflation. Blanchflower stressed that Bernanke will probably need to do a second quantitative ease to curb the threat that the economy faces. In a hat tip to my friend, KM, he noted that the FED is caught in an asymmetric policy stance: The FED has to allow some inflation in order to be sure that the deflationary threat has truly passed. Bernanke and the others feel that it is easier to curb inflation than to halt a deflationary slide.

This is the logical outcome of the success of Paul Volcker in the early 80s, who defeated inflation. This is in line with what we have continued to write about. The FED is far more concerned with the nightmare of deflation in an over-indebted economy. The dilemma the markets face, from currencies to equities, is how to trade the nuances of the intricacies of this assymetry. The longer the economic data remains stagnant, the more ominous the political environment.

Peter Diamond, the third FED appointee, is an economics professor at MIT. He was one of Bernanke’s teachers, but his expertise is in taxation and behavioral economics. Plus, he has a deep knowledge on how to overhaul the entitlement programs. He co-authored a book with the recently resigned budget director, Peter Orszag. We don’t know how he fits in with the growth-oriented FED members, but at this point we assume a close relationship with the FED Chairman.

The FOMC’s minutes reveal the deep concern with deflation. So we tell Bernanke: relax, help is on the way. This will help the FED chairman combat the change in policy that the FED hawks wish to pursue. The FOMC minutes have made the dollar bulls a little more nervous as the FED has let it been known on which side it will err.

Tags: Alan Greenspan, Bernanke, David Blanchflower, Fed, FOMC, Janet Yellen, Paul Volcker, Peter Diamond, San Francisco Fed, Sarah Bloom Raskin

This entry was posted on July 15, 2010 at 12:09 pm and is filed under Federal Reserve, FOMC. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.