Pacifica Partners’ Financial Post Weekly Column – Oct 29th 2009
In 1979, President Jimmy Carter named Paul Volcker to head up the Federal Reserve. As chief of the US central bank, he was instrumental in ultimately slaying the inflationary spiral that was running rampant. To this day, he is one of the most respected voices on the subject of inflation. He was an advisor to the Obama campaign and has a position in the current administration. However, some insiders say that Volcker’s voice in the administration is being muted by competing viewpoints.
Left to Right: Bank of Canada Governor – Mark Carney, Former Federal Reserve Chairman – Paul Volcker, Federal Reserve Chairman – Ben Bernanke
Volcker is respected in part because he was vigilant in maintaining his independence from the political pressures of Congress and the White House. He learned the value of independence by watching the mess that his predecessor, Arthur Burns, made when he was told by President Nixon that “No one ever lost an election on account of inflation.” In short, Nixon was using the Federal Reserve to ensure that Americans were not going to be able blame him for high interest rates and a weak economy. As we now know, the 1970s saw the US economy engulfed by high inflation and rising unemployment.
It was not until Paul Volcker took the helm of the Fed that credibility in US monetary policy returned. Volcker ratcheted interest rates up far above what anyone expected at the time. This resulted in a deep recession in the early 1980s and almost made Ronald Reagan a one term President. However, the Volcker Fed pressed on. The bond market, realizing that they had a credible inflation fighter on their side, drove down interest rates to the point that many homeowners since have never had to deal with a mortgage rate they couldn’t afford.
Today, the bond markets are questioning the Fed’s resolve once again. Many investors point to the nosedive of the US dollar as proof that capital is fleeing the United States in response to today’s low rates. As current chairman of the Federal Reserve, Ben Bernanke is caught between two opposing schools of thought. On one side, there are those who argue that US monetary policy is too lax and that the return of inflation is around the corner. On the other side, some will argue that given the seemingly precarious state of the economy and high unemployment, the Fed has no choice but to keep interest rates “lower for longer”.
It is not an enviable position. If the Fed raises rates too late, inflationary forces could become rampant. If it moves too soon, the economy could end up in a tailspin and unemployment could far exceed the 10% threshold. The issues confronting the economy are perhaps the most complicated that any Federal Reserve has ever faced. Even in the midst of the Great Depression, at least the issues were more clear cut. Today, the Fed has to balance China’s concerns and the political jockeying of Congress and the White House. Not to mention the modern global financial markets which are quick to show their displeasure by sending gold rocketing higher and/or the US dollar tumbling at lightning speed.
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