Volcker warns of Consequences - 70s style inflation - Fed creators rolling in their graves
These comments on Capitol Hill today by Paul Volcker are as sobering as anything I've read to date. In an understated but direct style characteristic of all Fed chairmen, he paints a portrait of severe hardship ahead as inflation continues, the economy tanks as confidence in Fed to fight inflation is lost (already on shaky ground), and the risk of a systemic dollar collapse. Sounds like a walk on a tightrope... he says we need some dollar devaluation to stabilize the economy, but that we can't let it get out of hand. So far, the Fed has been expert at the former. :)
WASHINGTON (Thomson Financial) - The US economy is not now in the kind of stagflation crisis it had been in, in the late 1970s, former Federal Reserve Board Chairman Paul Volcker told Congress today, but it's not impossible.
'I think there is some resemblance now to inflation in the early 1970s,' he warned the Joint Economic Committee. The economy obviously does not have the full-blown, double-digit inflation crisis that finally appeared, but he said, 'there is an underlying tendency to inflation.'
Volcker also told the committee that the Consumer Price Index may understate the actual rate of inflation. For example, during the real estate boom, the housing component of the CPI rose only slightly.
And to consumers, 'when food and energy are running high, not for a couple of months and dropping, but running high for years, it doesn't sound quite right, it doesn't feel quite right.'
The former Fed chairman was called before the committee to discuss the causes of the credit market crisis and potential remedies, but members could not resist asking about his outlook.
Fundamentally, he said, 'the outlook for financial markets depends on the outlook for the economy. If we were to go into a recession we could have another wave of defaults.'
Volcker did not forecast a recession, rather he talked about a necessary rebalancing of an economy that depended too much on consumption financed with borrowing.
'Somehow that has to change,' he said. 'It's a kind of a rough ride but we have to have it happen to avoid more severe consequences.'
And in fact, consumption is declining and exports rising, 'laying the basis for a sustained recovery.'
That's partly because of the decline of the dollar, which Volcker called 'necessary to get our economy rebalanced.' But the decline 'can't get out of hand,' he said to the point where loss of confidence in the dollar imperils its role as the world's reserve currency.
In his analysis of the credit crisis, Volcker said the mathematical modelling and financial engineering behind the structured investment products involved are inherently incapable of accounting for the human element of market behaviour.
And, having necessitated Fed intervention to rescue the markets and economy as a result, the investment banks which used the financial innovations now need to face the same kind of regulation as commercial banks.
'I believe there is no escape from the conclusion that, faced with the kind of recurrent strains and pressures typical of free financial markets, the new system has failed the test of maintaining reasonable stability and fluidity,' Volcker said.
Asked about the Fed's arranged merger of Bear Stearns (nyse: BSC - news - people ) by JP Morgan Chase, he said 'I can understand' why the Fed felt it had to act as it did. The more important question, though, is whether better regulation and supervision could have prevented the collapse in the first place.
Faced with the threat of a cascading breakdown of financial markets, the Federal Reserve felt compelled to extend its safety net with long-dormant emergency powers.
'The natural corollary,' to that Volcker said, is that systemically important investment banking institutions should be regulated and supervised along at least the basic lines appropriate for commercial banks they resemble in key respects.'
By its intervention in the mortgage and other credit markets, the Fed may imply official support for a particular sector of the economy. 'The creators of the Federal Reserve could be rolling over in their graves knowing the Fed is buying mortgages,' he said.
The intervention, in turn raises potential questions about the political independence of the Fed.
Volcker said the Fed should have the lead role in financial regulation, but to take that on, it needs a reorganization with a senior administrator and a stronger staff if it's to fulfil that roll.
Volcker Says Fed Interventions Risk Political Battles (Update4)
By Craig Torres
May 14 (Bloomberg) -- Former Federal Reserve Chairman Paul Volcker warned that Ben S.Bernanke's interventions in securities markets opened the door to political interference that may threaten the Fed's independence in setting interest rates.
``Intervention in a broad range of credit-market instruments may imply official support for a particular sector of the market or the economy,'' Volcker said in testimony to the congressional Joint Economic Committee in Washington today. Support for specific markets ``throws them into political battles,'' he said in an interview, referring to the Fed.
Volcker's comments are his most detailed warning yet about the consequences of the Fed's rescue of Bear Stearns Cos. and taking on mortgage securities from bond dealers. He joins former Fed chief Alan Greenspan in anticipating greater meddling with the central bank at a time of rising inflation pressures.
``Independence is integral to the central responsibility of the Federal Reserve'' for ``the conduct of monetary policy,'' said Volcker, 80, who served as Fed chairman from 1979 to 1987, and is credited with halting runaway inflation. He was succeeded by Greenspan, who retired in January 2006.
Greenspan, 82, wrote in his book ``The Age of Turbulence,'' published before the Fed's credit-market actions, that ``the dysfunctional state of American politics does not give me great confidence in the short run'' and there may be ``a return of populist, anti-Fed rhetoric.''
Like Early '70s
Volcker, who engineered a surge in interest rates to 20 percent when battling consumer price gains 18 years ago, said ``there is some resemblance to where we are now in the inflation picture to the early 1970s.'' The Fed failed to contain a pickup in prices at that time, spurring the acceleration of inflation later that decade, he said.
``If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary pressures'' and buttress the dollar, ``we will be in real trouble,'' Volcker said. ``That has to be very much in the forefront of our thinking. If we lose that we are back in the 1970s or worse.''
Consumer prices rose 3.9 percent in April from a year before, compared with an average rate of 2.7 percent over the past decade, a Commerce Department report showed today. Volcker said there's ``a lot more inflation'' than reflected in government figures.
Congressional lawmakers pressed the Fed in March and April to widen the collateral it accepts for loans from securities dealers to include debt backed by student loans. The central bank did extend its Term Securities Lending Facility to add asset-backed securities on May 2.
The Fed's recent actions ``will invite greater scrutiny,'' said David Jones, a former Fed economist who has written books on the central bank. ``The Fed could not be at a more delicate moment, and to the extent that Congress does try to lean on the Fed, it will impinge on its independence at a critical juncture.''
The Fed has created three new instruments since December to alleviate credit strains, including direct loans to nonbanks for the first time since the Great Depression.
Bernanke, 54, said yesterday that financial markets remain unsettled and the central bank will increase its auctions of cash to banks as needed.
`Far From Normal'
While markets have improved, they remain ``far from normal,'' Bernanke said in a speech to an Atlanta Fed conference at Sea Island, Georgia. ``We stand ready to increase the size of the auctions if further warranted by financial developments.''
The flight from risk since August has made financial institutions reluctant to lend to each other, driving up banks' borrowing costs. That has increased the threat to economic growth already posed by the worst housing recession in a quarter-century by making banks more reluctant to extend credit.
``The Federal Reserve as other central banks is obviously taking onto its balance sheet a lot of mortgages these days,'' Volcker said. ``Well, the creators of the Federal Reserve system would be rolling over in their graves if they knew the Federal Reserve is buying mortgages.''
Volcker blamed Fannie Mae and Freddie Mac, the government- chartered companies that are the biggest sources of financing for U.S. housing, for failing to take a stronger role in the crisis.
``Where are Fannie Mae and Freddie Mac?'' Volcker asked. ``These are two congressionally created agencies with the specific responsibility'' of supporting the mortgage market, he said.
Volcker said the Fed's rescue of Bear Stearns and its loans to investment banks now mean both officials and market participants will assume the central bank will intervene similarly in the future. That means tighter regulation of investment banks is critical, he said.
``Systemically important investment banking institutions should be regulated and supervised along at least the basic lines appropriate for commercial banks,'' the former Fed chairman said.
Volcker also urged an overhaul of the central bank's internal organization, with a senior official designated by law to take charge of ``administrative responsibility.''
Democratic Senator Charles Schumer of New York, who chairs the congressional panel, said a new single regulator is needed to oversee financial regulation.
While the Securities and Exchange Commission was charged with overseeing Bear Stearns, its main focus is on disclosures to investors, Schumer said in an interview with Bloomberg Television before the hearing. The Fed, which in March pledged $29 billion of financing to secure the takeover by JPMorgan, had no jurisdiction, the senator said.
The Fed ``had to do what they had to do, but they're on tricky ground because the regulatory structure is so ossified,'' Schumer said. He predicted that a wider effort to change U.S. financial regulations would take some time and probably awaits a new presidential administration after January.
Volcker called on lawmakers not to pressure the Fed to intervene on behalf of specific institutions or credit markets. Such political interference ``is the way to destroy the Federal Reserve in the long run.''
To contact the reporters on this story: Craig Torres in Washington at email@example.com.
Last Updated: May 14, 2008 14:32 EDT