Undercurrents

m* has been digesting the torrent of "progress reports" and related commentary, all released over the last day or two. The trends in place before this week are still in place. China is expanding at an astounding and accelerating rate. As measured inflation is at the higher end of our official comfort zones with housing pressing down and global growth pressing up. Forecasts for US growth are coming in a touch with consumer spending starting to soften. But the Fed remains on hold, mindful of the connection between food inflation and un-anchored expectations, while also keeping an eye on stress in the financial sector, etc, etc... Meanwhile oil continues to climb and the dollar continues to melt. This is not new.

However those buyers of bonds back to 5% are to m*'s way of thinking playing a game whose rules may have changed since the last financial crisis. Granted, is there anyone who has not been conditioned since this liquidity party started two decades ago to believe it is the central banks' responsibility to answer any and every crisis that threatens the steady march of credit expansion with a flood of cheap money to allow the party to continue? Probably not. We know the no consequences Greenspan put has replaced decades of dour punchbowl management.

But central banks now face a tougher set of conditions than they have in the past. The global economy is synchronized like never before and running full tilt. Inflation, not just the dollar weakening kind or the asset price kind, but real inflation, is starting to crop up in all sorts of places and is as globally linked as the supply chains that feed our people and our economies. For example food prices were reported as rising at 4.5% or higher in the US, China, and Israel this week. Central banks around the world are in tightening mode as inflation targets are being exceeded and expectations risk becoming un-anchored. The benign inflation environment that has existed for two decades and allowed central bankers considerable latitude to lower rates rapidly in response to fluctuations in the supply of credit no longer exists.

Central bankers today face a decision that was par for the course for bankers of old - whether to choose the primary goal of price stability or the secondary goal of full employment? In previous eras, central bankers felt obligated to occasionally put the brakes on, to allow unemployment to rise, even to cause it to rise by raising rates. However that has become much harder to do these days. With the shift from bank lending to capital markets finance, the opacity of credit creation through derivatives, and dare I say it, an intolerance for hardship of any kind among voters. These days the levers at the Fed's disposal need to move much farther to have an impact while the will to move them may be less than ever before.

The Greenspan era Fed, with it's belief in a new and "permanently" higher rate of productivity afforded by the internet (!) and an intense fear of a Japan style deflation (remember "helicopter Ben" and those used car prices?) believed to the horror of monetarists and economic moralists everywhere that it had the power to choose full employment without affecting price stability. However, like the trade deficit, entitlement healthcare spending, tax breaks for the rich, profligate oil usage, and ill-conceived and incompetently run wars in foreign lands, that is check written that must eventually be paid (in devalued currency naturally). The dismissal as a society of difficult trade-offs and hard choices is a symptom of these times.

What about the unprecedented amount of leverage in the system? Does that not mean the banks can talk about vigilance all they want but will still be forced to rescue asset markets and leveraged financial intermediaries should a crunch occur? Perhaps. At the margin, what matters is employment - the Fed's second policy goal. Changes in asset prices by themselves do not factor into the Fed's employment calculus. Wealth effects - the health of the "animal spirits" that incite both spending and entrepreneurial risk taking are probably real, as we've learned in the last housing boom. However, unless collateral can not get a loan, the current Fed leadership, steeped in scholarship on the Great Depression and the breakdown of credit intermediation as it is, may not be as sensitive to dampened spirits as the previous leadership seemingly was. Conceivably, there could be severe distress in financial markets, and even a pensions crisis, without a major policy change from the Fed. Only if unemployment threatened to pick up substantially would the Fed be obligated to shift policy.

Is the Bernanke Fed up to the challenge? It is an interesting situation to say the least.