Thursday, August 30, 2007

Time to Do the Wrong Thing

Something is wrong here. Even though the Fed and its chairman (not to mention anyone who has studied the evidence rigorously) believe that there was never a Greenspan put, the Fed seems to feel that it has to be very careful not to create the impression that the Greenspan put exists. In other words, to some (hopefully not very large, but I'm not sure) extent, the appearance of bailing out Wall Street is now an argument to the Fed's objective function. Which means that, under some circumstances, the Fed will deliberately follow bad policy -- bad meaning suboptimal with respect to the balance of growth and inflation risks -- because the better policy would have the appearance of being too Wall Street friendly.

In fact, since the history of the Greenspan era suggests that following an ex ante optimal policy for growth and inflation does create the impression that there is a Greenspan put, the Fed can expect that it will occasionally have to make a deliberate mistake. Something is wrong.

If the Fed doesn't cut the federal funds rate target in September -- barring a truly dramatic improvement in credit conditions or a series of economic reports that are either stronger or more inflationary than expected -- I will, as I said a few days ago, be puzzled, but perhaps not all that puzzled after all. By such inaction in the face of widening spreads and credit rationing, I argued then, the Fed would be "either making a mistake or acknowledging that they made a mistake earlier by not having raised the rate higher in the first place." But I hadn't considered the possibility of a deliberate mistake. Does one need to sacrifice a virgin on the altar of Moral Hazard Avoidance, not because it will in fact result in a better harvest, but because the people think so, and they won't bother planting unless you do?

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