Friday, February 10, 2006

The invisible fence of monetary policy

Every time the government moved to enlarge the flow of benefits to the population at large, or to this or that group, the assumption was implicit that monetary policy would somehow accommodate the action. A similar tacit assumption was embodied in every pricing decision or wage bargain arranged by private parties or the Government. The fact that such actions could in combination be wholly incompatible with moderate rates of monetary expansion was seldom considered by those who initiated them, despite frequent warnings by the Federal Reserve that new fires of inflation were being ignited.

Facing these political realities, the Federal Reserve was still willing to step hard on the monetary brake at times-as in 1966, 1969, and 1974-but its restrictive stance was not maintained long enough to end inflation. By and large, monetary policy came to be governed by the principle of undernourishing the inflation process while still accommodating a good part of the pressures in the marketplace. Arthur Burns

Government policy acts on the population at large in two main ways. Many citizens, at least in a well functioning society, go along with policy either out of fear of sanctions, or simply because they are law abiding citizens. A hopefully smaller set of citizens will not go along with policy and thus become object lessons. Government policy enforcement then determines which set grows or shrinks over time. This is not to argue the law is the only means by which cultural behaviors are shaped, which I don't believe. Rather, to the extent the law has an effect, i
n general, harsh, equally applied sanctions will lead more to stay within the law while loosely applied, less harsh sanctions will lead to the opposite.

While monetary policy is, at least currently due to the worship thereof, not thought of as a form of government policy sanctions, I think this is a useful heuristic when tightening comes into play. Just as the state may choose to criminally sanction fraud, insider trading, or drug dealing to change people's behavior so too does the Central Bank monetarily sanction indebtedness.

If the criminal sanctions for
fraud, insider trading, or drug dealing were only enforced say every three years, and even then not harshly, over time I would expect to see those behaviors become more entrenched in the population at large. Equally if the monetary sanctions for indebtedness were (are) only enforced sporadically and rarely for long or with harsh penalties, indebtedness will (has) become more entrenched in the population at large.

Are you familiar with the "invisible fence?" It's a wire buried in a perimeter around your yard which, when operating, will first cause a whistle in a special dog collar to sound and then, assuming your dog doesn't move away from the wire, send a shock of variable voltage into your dog. Dogs deal with this behavior modification tool much as humans deal with sanctions. Some learn very quickly, while some take longer and higher voltages.

Once the dogs learn the new boundaries some people turn the shock voltage down or off altogether, not wanting to hurt their dog. They then hope that the whistle alone will do the trick. Sometimes it does, but over time, the whistle alone is rarely enough. Once the whistle alone fails to do the trick, then owners face a dilemma. They can try to recreate the association of whistle and pain but this usually requires much higher voltage. Worse, once a dog learns that the shock only hits it when it crosses the wire, it is much more likely to "jump the fence" regardless of the voltage. On rare occasions, the dog gets tired of being shocked altogether and bites the owner.

The practice of monetary policy described by Arthur Burns and practiced by the Greenspan Fed seems to me like the kind hearted invisible fence approach. There is this hope that people will remember the pain of restrictive monetary policy or persistent market intervention and change behavior at the hint thereof. Some Central Bankers, like dog owners would prefer not to hurt their charges.

Yet, just as a properly administered invisible fence keeps dogs from being run over by cars, inter alia, properly administered monetary policy help the nation avoid inflation, and other manifestations of overextension, such as external account deficits which can lead to wars, inter alia. The dog owner, hopefully being aware of the possible dire consequences will restrict the dog's ability to roam, while the Central Banker, hopefully being fully aware of the possible dire consequences, will, to borrow a well worn cliché, take away the punchbowl, before the party gets out of hand.

It is, as Arthur Burns describes, a difficult task and beyond the ability of the Central Bank to enforce alone if other segments of society refuse to admit the possible dire consequences. A few months of an inverted curve that is quickly aborted at the first real signs of economic pressure is not, in my view, sufficient to dampen inflation pressures over the medium term. As one of the current major culprits behind rising national indebtedness is government itself, one of the slowest responders to monetary policy, particularly when external finance is available, the Central Bank may find its invisible fence quite ineffective.

To wit, judging from the most recent auction result reports and bond market action, the US federal government continues to have little trouble financing its deficits. This means behavior changes will be forced on the private sector. Within the private sector, the household and corporate financial sectors seem to me the possible swing factors. Of these the latter is a protected industry which leaves the household sector.

Within the household sector, mortgage related finance is the key. Will the Fed be able to squeeze real estate debtors sufficiently to bring about a radical shift in economic behavior? Using our dog analogy, will policy makers be able to enforce sanctions without being bitten?

I doubt the household sector can do the heavy lifting on its own without a substantial, long lasting credit restriction. I also don't think the executive branch is willing to risk such a squeeze given low approval ratings. Given that the seven voting members of the current Fed have now all been appointed by President Bush, his administration might have some say in the implementation of policy. Unpopular wars and coincident credit restriction induced recessions are rarely good for the party in power.

Over the short term, I'm interested to see if the invisible fence is working at all. That is, are higher short term rates slowing the mortgage finance machine? If, for instance, foreign demand for mortgage debt grows, higher rates may have much less of an effect than expected. This, it seems to me, would surprise the markets. Secondly, how long will the Fed keep the curve inverted or more generally restrict credit to the household sector?

My guess is that policy makers and big players in the financial markets feel confident the invisible fence works. I think they will be surprised both by its lack of efficacy and the swiftness with which the dogs begin to snarl and bite even at low voltage.