Worst Case Scenarios: Why the Fed Tends to Overtighten

Thursday, June 01, 2006 | 07:20 AM

Forget, for the moment, the specifics of the May 10 Fed Minutes. Instead, consider the decision making process the FOMC goes through.

When making complex decisions with serious ramifications, it is useful to understand what is at risk if you are wrong. That one factor impacts various outcomes dramatically.

Its a given that the future is unknowable. The complexity of the economy, random events, unexpected interactions, dumb luck -- force all forecasters to recognize the inherent possibility, and indeed, high likelihood of error. Typically, that recognition colors policy making. (Consider recent examples where expectancy analysis was ignored in the policy making process -- with dire results).

Once you get through that process of error expectancy, then play out the various decision tree possibilities: The results are why the Fed tendency to overtighten is all but a fait accompli.

And, we like it that way.

Why? What is the worst case scenario if the Fed Overtightens? The economy slows, maybe we even have a recession. Not to make light of what is always a painful situation, but -- so what? Recessions are a normal part of the business cycle. The U.S. economy is flexible, multi-faceted and resilient enough that a mild recession -- or even a strong one -- is a minor inconvenience in the grand economic scheme of things.

Consider: A recession reprices overvalued assets; It creates a cathartic cleansing that forces efficiencies where there were none before. It removes excesses that have developed.

Has the U.S. ever not bounced back from a recession? Of course not. Over the next century, we will have a dozen or more recessions, and an equal number of recoveries. 

But consider the alternative error:  What happens if Inflation is no longer contained -- if it gets away from them?

That is a far, far worse outcome than a recession. I am old enough to remember the nightmare of the 1970s. I have no desire to live through THAT again (and I'm not referring to Disco, Bell bottoms or Nixon). It was FUGLY:

>
1970s Inflation: Worse than Disco
1970s__2

Source: Economagic

>
Once inflation is no longer contained, it becomes a runaway wildfire. The Fed -- indeed, central bankers everywhere -- find it difficult to play catch-up. Inflation is self-reinforcing -- it forces everyone in the system to raise prices, pass along increases, demand higher wages. It feeds upon itself.

The response? The Fed goes Volcker (now, a verb) on the economy: They force an even more severe recession. The medicine to recover from this is a brutal, economic chemotherapy. It can take a decade to recover from uncontained inflation -- or the cure. 

>
That's the dilemma confronting the Fed. What is the worst case scenario if they are wrong and overtighten? We get some unpleasantness -- but nothing fatal. No one likes recessions, but they are a natural part of the business cycle. (We don't care for death either, but its a part of life). After the Recession, comes the Recovery.

This is why the Fed tends to overtighten. We always -- ALWAYS -- rebound from a recession. Relatively quickly, also. But 1970s-style inflation is a spectre that haunts the dreams of all economists -- especially those who sit on the Fed.

>
Given this choice of potential negative outcomes, what would you do?

Thursday, June 01, 2006 | 07:20 AM | Permalink | Comments (39) | TrackBack (3)
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Listed below are links to weblogs that reference Worst Case Scenarios: Why the Fed Tends to Overtighten:

» "Why the Fed Tends to Overtighten" from At These Levels
The Big Picture on the perrenial Fed dilemma. [Read More]

Tracked on Jun 1, 2006 2:40:35 PM

» Going Too Far from Bear Mountain Bull
Were constantly hearing the whining of those that complain about the Fed raising rates, and theyre convinced that the Fed always goes too far - which they do - and the economy lapses into recession - which it often does. But over at The ... [Read More]

Tracked on Jun 1, 2006 6:01:27 PM

» Bernanke from The Big Picture
Let's cut Ben Bernanke a break: the present situation wasn't of his making; he merely inherited a bad economic set up. Slowing growth, rising inflation, high energy costs, a real estate dependent economy, and the longstanding problem of excess liquidit... [Read More]

Tracked on Jul 19, 2006 9:41:32 AM

Comments

"Inflation is self-reinforcing -- it forces everyone in the system to raise prices, pass along increases, demand higher wages. It feeds upon itself."

You've just reinforced my stance that inflation is not only a monetary issue, but also a psychological issue, which is why we get a steady stream of open mouth committee members giving speeches about how tough the Fed is going to be on inflation, as if telling the average joe this b.s. will make him feel better about his rising costs, excluding those things that are rising in price.

It's all crap anyway as the Fed is the creator of inflation. Break out your W.I.N. button, Barry.

Posted by: Uncle Jack | Jun 1, 2006 7:40:29 AM

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