The Fed Transcripts - The Emperor Has No Clothes

"How could I have been so mistaken as to have trusted the experts?"- John F. Kennedy (after the Bay of Pigs fiasco)

More people today are learning what many have known for some time:  the Federal Reserve policymakers are a collection of arrogant clueless elitists.  If it weren't for the fact that their actions cause widespread misery, I would label them as a joke. The latest transcripts will be eye-opening for many.  After all, to the mainstream press, Federal Reserve Governors are viewed as rock stars. And Bernanke is lead singer.
 
Well, the 2006 transcripts have seen the light of day and they are, to put it mildly, embarrassing and highly revealing.  How will people keep from laughing when Congress next asks Bernanke for his view of the economy?  And what about Geithner?  Here's what he had to say before the housing debacle:

"We believe that, absent some large, negative shock to perceptions about employment and earned income, the effects of the expected cooling in housing prices are going to be modest,"

Our present Treasury Secretary obviously had no clue on the relationship between the financial markets and the mortgage market!  Recall that the Fed meets daily, with so-called primary dealers, to discuss markets and that the mandate of the Fed is to ensure a well functioning banking system.

Bernanke got a laugh when he responded,

"Anything to report on co-op prices in Manhattan?"

To keep the joke running, Geithner responded,

"If you see hiring at the New York Fed go up substantially in the market, that will be a good leading indicator of housing prices reverting somewhat," 

Yellen, president of the San Francisco Fed, chipped in on Greenspan handing the Chairmanship to Bernanke with,

"And if I might torture a simile, I would say, Mr. Chairman, that the situation you're handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot,"

The evidence is clear that the Fed had no clue how housing affected the economy, how Wall Street and the housing market were interconnected, and the appropriate policy to enact given the storm about to unfold.  This will be difficult for many to accept because, for many, it is hard to see that the emperor has no clothes.

But it goes beyond this and has more important implications.  The problem is that the Fed caused the crisis, and this is what the foxes inspecting the henhouse are missing in their rock star idolation.  The evidence clearly shows that, if the Fed had not lowered short-term interest rates to 1% in 2003, thereby throwing gasoline on the fire, the ensuing runup in housing prices and subsequent crash would have never occurred.  Forget rating agencies, the slime bags at Countrywide, Fannie Mae, and Freddie Mac, and even the government mandate to issue mortgages to the lower income sector.  They are all scapegoats.  Greed would never have had the chance to go hog wild if the Fed hadn't set the stage by pushing rates to historically unprecedented levels.

To fully grasp this, think about what would happen if the government set the price of gasoline at $1/gallon.  Clearly car dealers would go bonkers.  They would set financing terms at ridiculously low levels, offer car loans extended to 10 years, push gas guzzlers, etc.  The next thing we would see is that grid lock has worsened, pollution has worsened, accident rates have gone up ,etc.  Who would be the culprit here?

What should be done going forward? S hould we let the arrogant blind continue to steer the ship?  There is one more point that is worth making that bears crucially on how the Fed operates.  Almost from day 1 in an introductory economics course, students are taught that controlling prices distorts resources allocation.  Typically this is presented in terms of the minimum wage and rent control.  In both instances, there are well-documented impacts via unemployment and public housing that is boarded up and abandoned in the inner city.  Guess what?  The Fed controls the most important price in the economy by setting the federal funds rate.  This is the price of short-term money.  This determines the rate on adjustable rate mortgages.  This affects the rate on 30-year mortgages and other long term rates.  It even affects the price of goods in international markets via the impact on the value of the dollar.

To put this differently - the Fed snubs its nose at what is taught in introductory economics and, in its arrogance, believes it knows more than the marketplace on what these important prices should be.  The transcripts that have been released (and those that will be forth coming) are clear evidence the emperor has no clothes.

What should it do?  IMHO, the Fed would be better off controlling M1 (up 18% over the 12 months ended in December!) and letting the market determine the appropriate rate of interest, i.e. the price of money.  This, of course, is what former Fed Chairman Volcker did to defeat inflation and put the economy on a long-term growth path in the early 1980s.