August 19, 2009
PULLING THE PLUG ON THE GREAT STIMULUS
Warren Buffett advises in today's New York Times that the Great Stimulus must one day be clipped as the Great Recession fades. As the Oracle of Omaha explains, the "enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects."
We've been making a similar argument for some time, although the cause seemed lost when we advised in May that the crowd should recognize that the Federal Reserve must begin raising interest rates at some point. That future has been easily ignored, and perhaps for obvious reasons, given the economic events of the past year or so. But the arrival of Buffett's warning suggests that sentiment may be set to turn by focusing the crowd's gaze on the inevitable. If so, that's healthy, if only because recognizing the risks that loom, as opposed to the ones that just passed, is always a productive exercise in managing money and otherwise boosting one's odds of survival.
As we wrote in May, "At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard. We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming."
If more pundits and policymakers are on board with this outlook, chalk up another win on the side of progress. But lurking behind this rise in enlightened thinking is another problem, which can be summed up as the expectation that the central bank will begin tightening at a time when it's clear that the economy is on a sustainable path to recovery. A nice idea, but like fairy tales and campaign promises, danger lurks in accepting such notions without question.
For the same reason that mere mortals can't hope to sell exactly at market peaks or buy at bear-market bottoms, the Fed is destined to be early or late at the start of the next great change in monetary policy. This is a critical point because it belies the notion that the Fed will be able to tighten monetary policy at just the right time and keep everyone happy in the process. Wrong. Not only does the Fed face a tough challenge in purely monetary policy terms, the potential for political and even economic fallout are commensurately large as well.
Central banks, like the rest of us, are making real-time decisions with lagging data. Even worse, it takes time to assess if the decisions were timely, or not. The folly or fortune of policy choices made today will be evident a year or two hence. It's a bit like a surgeon working in the dark and then finding out a year later if the patient survived.
So be it. That's how running fiat currencies works: it's a job that's highly subjective in real time. The question is whether the crowd understands what's coming. Normally, the margin for error is relatively wide in the highly subjective business of central banking. These days, that margin has shrunk considerably, even if the ramifications won't be obvous for several years.
No one will ring a bell at the ideal moment for tightening. The fact that the Fed's timing wasn't perfect in the years running up to the Great Recession reminds that fallibility infects the institution, just as it does every other area of human decision making.
What's more, when the Fed launches the new monetary era, the criticism is likely to be deep and broad, from politicians and investors, businesses and the people on the street. No one has perfect information and insight, but that doesn't stop anyone from thinking (and speaking) as if they did. The net result: lots of noise and confusion.
With the benefit of hindsight at some point, it's a virtual certainty that we'll recognize that the Fed was too early, or too late. Heck, maybe they'll get it exactly right this time, although we're not holding our breath. In any case, such things can only be determined after the fact.
The stakes are high, perhaps unusually high compared with previous business cycles of recent vintage. But at least we know what the two main threats will be. On the one hand, the central bank runs the risk of choking off the incipient recovery by tightening too early. At the other extreme, the central bank may wait too long and thereby give inflationary pressures a foundation to pester the economy for some time after.
No, these risks aren't absolute. One or the other may arrive but in moderate form, which still leaves the natural forces of inflation-adjusted growth to dominate eventually. Nonetheless, let's not forget that one or the other still looms. Markets and economies are forever evolving, as are the embedded hazards and opportunities. Perhaps the biggest risk of all is thinking otherwise.
Posted by jp at August 19, 2009 9:16 AM
And so with the massive deflation we have now, and all the toxic assets remaining on the banks books, you think the economy is recovering and growing? Look, Buffet's last call to buy stocks didn't look so great and would it be fair to say that as an owner of financial institutions his worry about inflation might be in his self interest?
Posted by: me at August 19, 2009 1:23 PM