Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

April 29, 2008

Will the Fed Broaden Its Focus?

The Federal Reserve will almost certainly cut the target federal funds rate a quarter point to two percent on Wednesday. Fed watchers will be looking at the policy statement for clues as to whether the Fed will pause after cutting rates 3.25 percentage points since June.

The Fed may like to stop cutting rates. So far, rate cuts have aided homeowners with adjustable-rate mortgages and other borrowers with loans indexed to domestic interest rates; however, those cuts have not substantially increased bank lending.

Simply, no matter the prevailing interest rate environment, banks are frozen out of the bond market, where they have increasingly raised funds, over the last two decades, by bundling loans into securities. Having been sold loan-backed securities that were more risky and worth less than the banks represented during the subprime boom, the insurance companies, pension funds and other fixed income investors don’t trust the banks.

Despite changes in the leadership at some major financial houses, banks have done little to win back trust. Similarly, the bond rating agencies seem wedded to cozy relationships with banks, accepting payments from banks to rate securities the banks create.

The trade deficit—in particular, the rising oil import bill and stubborn deficit with China on consumer goods—is a drag on domestic demand equal to 5 percent of GDP. The falling dollar against the euro and other market-determined currencies has helped; however, oil is priced in dollars, and the dollar continues 40 percent, or more, overvalued against the yuan and several other Asian currencies.

Until Bernanke addresses structural problems in bank participation in securities markets—something Treasury and G7 proposals for financial market reform little address-- adequate bank credit to power an economic recovery will not be forthcoming, and unemployment will rise.

Until Bernanke challenges Treasury on trade and exchange rate policies, the trade deficit will pose a similar constraint on the economy. In this decade, as the trade deficit grew, consumers cut savings and borrowed more through the banks to shore up domestic demand. Essentially, Americans spent 105 percent of what they earned to keep the economy growing but that house of cards has now collapsed.

Bernanke must take on genuine banking reform and currency and trade policies, or his job is impossible. The latter are outside his portfolio, but past Federal Reserve Chairman have voiced concerns about federal budgets, entitlements and other policies that made their stewardship more difficult.

For now, Bernanke seems more comfortable courting Congressional Democrats by focusing on consumer lending practices—abuses by mortgage brokers, appraisers and credit card companies. This enhances the likelihood of reappointment by a Democratic President. However, if he continues this tack, he will ultimately find his name inscribed in history, not along side Paul Volcker and Alan Greenspan who conquered inflation and facilitated great prosperity, but rather along side the likes of Arthur Burns and G. William Miller, who, though politically adroit, gave us The Great Inflation and economic malaise.

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