Smith Faculty Opinion Article	November 12, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

The Limits of Federal Reserve Policy

Federal Reserve policymakers and critics labor under false assumptions. Hawks believe tighter credit can stave off inflation. Doves hew to lower rates to mitigate risks of recession.

Rocketing oil prices may accelerate inflation, while the credit and housing crises, and the still huge trade deficit threaten recession. However, these cannot be countered adequately by modulating interest rates.

China and India are growing ten percent a year, causing global oil demand to outrun supply and pushing prices to near $100 a barrel.

The United States consumes only one quarter of the worlds oil, and accounts for a smaller share of growth in demand. Trimming U.S. GDP by one or two percentage points, with tight credit, would slice an inconsequential fraction off global oil consumption, and little affect broader U.S. inflation. Yet, the drag of tight credit and higher gas prices on consumer purchases, together, could sink the U.S. economy.

The grip of foreign oil can be relieved only by higher auto mileage standards and tougher conservation measures than Congress is considering, and by further developing domestic petroleum, nuclear and alternative energy sources. Neither political party has demonstrated the courage to ask Americans to do what is possible and necessary.

Over the next 18 months, two million adjustable rate mortgages (ARMs) will reset to higher interest rates, and many homeowners cannot afford the payments. Without viable refinancing options, many homes will go on the market, and the recent decline in home prices could become a route. The negative consequences for consumer spending and unemployment are obvious.

Federal Reserve Chairman Ben Bernanke is encouraging financial institutions to exercise forbearance in restructuring ARMs but many cannot be reworked because of the covenants in mortgage-backed bonds. These loans must be refinanced but new loans cannot be written, because the market for mortgage-backed bonds has evaporated.

Investment banks that bundle mortgages into bonds get higher interest rates and larger profits when bond rating agencies conservatively estimate risks of default. These investment banks, not investors, hire and pay rating agencies creating ruinous conflicts of interest.

Standard and Poors and other agencies apply faulty methods to assess risks of default, and assign overly optimistic ratings to bonds. Investors who purchased these bonds have suffered large losses, no longer trust the agencies, and wont buy new mortgage-backed bonds.

Until bond rating agencies are forced to answer for their insidious behavior, return to a system of investor-financed ratings, and adopt credible methods for estimating risk, pension funds, insurance companies and ordinary investors would be reckless to purchase mortgage-backed securities. Without those investors, the funds to refinance ARMs, and mortgages for many other worthy home buyers, simply will not be available.

Lower interest rates would help avert some foreclosures, but cleaning up the bond rating agencies and other problems in bond underwriting is more essential to resuscitating the housing market.

Since the end of 2001, the annual trade deficit has increase from $353 to $713 billion, requiring massive borrowing from foreign private investors and governments. Much of those funds go into U.S. government bonds and other interest-bearing securities, keeping down the U.S. mortgage interest rates.

Foreigners are becoming impatient with reckless U.S. economic management, as witnessed by the recent drop of the dollar against the euro. Foreign nervousness could jack up the cost of foreign funds and U.S. mortgage rates. That would put more downward pressure on housing prices, further increasing the risk of recession.

Americans must bring down the trade deficit or risk crippling their economy through a run on the dollar and credit crisis, but trade with China and oil each account for more than 40 percent of the trade deficit.

China has insistently kept its currency undervalued against the dollar, to keep its exports cheap on U.S. store shelves. Without a significant revaluation of the yuan or American policies to counteract Chinas currency policies, China will have to purchase ever large amounts of U.S. debt or Washington and Beijing will cope with a severe U.S. recession.

The Congress and President have been willing to do little more than talk with China about these problems, leaving U.S. credit policy increasingly in Beijings hands.

Sooner or later, Congress has must confront the problems it does not want to genuinely address: energy, Wall Street corruption, and trade with China.

Until it does, Mr. Bernankes capacity to manage the economy with the traditional tools of monetary policy will be quite limited.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.