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Further Indication of a Stealth Tightening by the Federal Reserve

Posted by Larry Doyle on September 25, 2009 1:55 PM |

Policy wonks in Washington do not publish articles in major periodicals such as The Wall Street Journal in an attempt to develop a byline. Given the impact of commentary provided by high ranking officials within the Federal Reserve, any article would be reviewed multiple times prior to submission. The Fed wants to be sure any commentary is properly nuanced so as to send the desired message, while not unnecessarily upsetting the markets.

I enjoyed reading the tea leaves embedded in just such a commentary, The Fed’s Job Is Only Half Over, in today’s WSJ. The writer, Kevin M. Warsh, is a senior Fed official and a member of the Federal Reserve’s Board of Governors since 2006.  Mr. Warsh writes in a very professional fashion while laying out the Fed’s actions to date. His commentary gets most interesting in looking toward the future. While not negating the Fed’s policy statement released the other day, Warsh leaves little doubt as to which way the Fed is leaning:

In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.

What is Warsh saying? The Fed is going to need to withdraw liquidity from the system sooner than what economic indicators may indicate or market participants may desire.

“Whatever it takes” is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If “whatever it takes” was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve’s institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.

What is Warsh saying here? The Federal Reserve can not simply flood the system with liquidity to the benefit of market participants, but without thoughtfully considering the loss of its credibility.

Why is Warsh, on behalf of the Fed, releasing this commentary? In my opinion, I believe the Fed is becoming increasingly concerned that excess liquidity has flooded the system, driven asset levels too high, and the dollar too low. In the process, if liquidity were to continue to flow, the cost could be a dangerously precipitous decline in the value of the greenback.

Add it all up, and although the Fed does not want to spook the markets, this statement is an indication that the Fed is getting ready to take its foot off the accelerator. In the process, our equity markets should give ground.


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