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America Needs to Listen to Thomas Hoenig

Posted by Larry Doyle on February 26, 2011 2:07 PM |

I am not sure if anybody got the license plate of the truck that ran over me and then backed over me this past Wednesday. In any event, in between my various rounds of medication for the flu during the last few days, I watched a man whom I have referenced previously but to whom America needs to really pay attention. I am speaking of Thomas Hoenig, Chair of the Kansas City Federal Reserve.

I think very highly of Mr. Hoenig. He embodies the essence of ‘sense on cents.’ I welcome sharing a recent interview Hoenig provided to The Wall Street Journal’s Market Watch.

Savor this like a fine wine. Unlike most in Washington or around our nation, Hoenig not only ‘gets it’ but he has no problem in ‘telling it like it is.’

Federal Reserve Bank of Kansas City President Thomas Hoenig is going to step down in October when he reaches the central bank’s mandatory retirement age of 65, but he is not exactly going quietly into the night.

Hoenig is pressing his message that the Fed needs to move away from zero interest rates and that the $600 billion bond buying program was a mistake.

While Federal Reserve Chairman Ben Bernanke has tried to distance Fed policy from the recent spike in global food and fuel prices, Hoenig says the easy money stance is clearly a factor.

For most of his tenure at the Fed, Hoenig was perhaps best known for the party he is in charge of, the annual August retreat for global central bankers in Jackson Hole, that Hoenig turned from a bland reading of academic papers into the most-sought-after invitation-only gathering for economists.

In the past year, Hoenig has managed his own transformation. He has become the only central banker to catch and ride the wave of the small-government, anti-Wall Street sentiment of tea party Republicanism. A fawning article in Time Magazine recently called him a likely “prophet for a future that looks a little more like a distant past.”

Hoenig is blazing a trail as an outspoken critic of the Fed’s innovative quantitative-easing monetary policy, warning that the Fed’s zero interest rate policy and bond-buying program is a dangerous gamble that is likely to create asset bubbles in future years.

He has become an unlikely folk hero for his lonely votes against all policy statements from the Fed’s interest rate setting Federal Open Market Committee last year.

Hoenig also wins admirers on the left for his Don Quixotesque criticism of Washington’s policy response to the financial crisis, which he finds to be tepid and woefully inadequate. See related story on Hoenig’s views on banks.

With Hoenig now much sought after in Washington, does he plans a new career in the nation’s capital after he departs the Fed? With the customary twinkle in his eye, Hoenig smiles and says: “If asked, I will serve.”

Following are excerpts from an interview conducted by MarketWatch Wednesday:

Q: Your call to break up the big banks is unlikely in the current environment. Given the reality of Dodd-Frank law, what do you want to see happen?

A: You have to implement what you have as best you can. You need to focus on enhanced supervision, on the capital and on the resolution. That is what we have. I don’t think it is enough. I think over time it will dissipate as it has in each proceeding incident and therefore we will back where we are today. If we broke them up, we would still have cycles, no question about it, but it would be less pernicious. I think that is what we should pursue. In the meantime, the market would be more competitive, there would be better credit allocation at the local level.

Q: So the implementation of Dodd-Frank should be as strict as can be?

A: Already look at the discussions and speeches from the largest firms — “these capital standards are disadvantaging us, you need to ease off, we need to pay dividends.” I am saying — excuse me, you are undercapitalized. Build your capital up.

Q: In December, at your last dissent on the FOMC, you warned that the longer the Fed took to start hiking rates, the harder it would be to move? Can you elaborate?

A: You have this environment of very low interest rates. You have asset values that are moving up and the impact from an interest rate increase will be more dramatic as things are heating up.

If you think about it in 1979 when things finally got to be [hot] not only asset appreciation-wise but inflation, we had to bring it under control. You had this huge decline.

Let me use my example of agricultural land. It went from $4,000 an acre to $8,000 an acre. The implied [capitalization] rate is 4% to 5% maybe. What happens to the value if [the cap rate] goes to its long run trend of 7% to 7.5%? Those values come down by more than a third.

As you think about your moves, your increases, you are going to have more a shock effect on more things the longer you wait. And therefore it is going to be more difficult to do it. You will hear from the markets, from others — “you can’t do this, it will destroy us. You have to delay.” That is what worries me. And then only when you then have enough inflation pressure do you move. And then the effects are devastating. An individual I know from Japan, he describes that when they had their bubble. One of the things, other than just inertia, that kept [the Bank of Japan] from moving was that inflation was very low, and they knew if they moved in that environment, it wouldn’t be well received and they would have asset shock. So they delayed.

Q: You seem sanguine about the economy compared with some of your colleagues on the Fed.

A: I am not sanguine but I am not willing to think that because it is growing more slowly than we would like that therefore we can do nothing to anticipate the effects later on. We’d added more than a million jobs. I wish we could have added more, but we’ve added more than a million. I read the manufacturing surveys and they are strengthening. The housing market is out of equilibrium. It is going to take time. I can’t fix that overnight. As much as I would like to see things improve, by delaying actions to normalize policy, I increase the risk of major problems later on.

Q: What about risk of premature tightening squelching the recovery?

A: The point is when you do move, whenever it is, you are going to have negative effects and they will be larger the longer you wait. If the economy is improving, and I think it is, fundamentally, and you then allow your monetary policy to become more normalized, then it will improve in a more sustainable fashion. Your kind of unstable equilibrium will become more stable over time. But if you don’t do the right things in the right order, you continue to have an unstable equilibrium that falls apart on you at the most inconvenient moment.

Q: What about the headwinds, like credit, that are holding back the economy?

A: Credit is available. Banks are out hunting for good credit. Now housing is in trouble, but it is out of equilibrium and it is going to take time. But manufacturing is strong. Other services are beginning to rebuild. So the headwinds are the housing market primarily. And I am sorry but it is not something that just can be corrected overnight. As badly as it was distorted… trying to make shortcuts out of its recovery risks making it worse in the long run.

Q: Inflation is very low now.

A: Inflation is, but asset values are moving up. Inflation isn’t 1% in January and 6% in March. Inflation is a very insidious, slow process. It is moving up. And you can be very confident that if you keep policy highly accommodative for an extended period of time, the odds of inflation rising increases, unless you have an asset bubble pop which throws the economy into a worse recession. It is not a major problem now, but monetary policy is not tight now. It is not inhibiting the growth in the economy. If you took away [the extended period] language and you modestly brought interest rates back a little bit, it is still very accommodative policy, it is not tight policy.

Q: Why not sell assets and leave rates alone until the Fed’s balance sheet is more normal?

A: I would have been fine with that but we chose not to. We have chosen to increase our balance sheet. We are easing into a recovery. So I voted against QE2 for that very reason.

Q: So getting off zero is very important.

A: Getting off zero is very important for the economy. I tell people do you know any markets that work well for the price of zero? Would you expect credit markets to work any better in the long run?

Q: On commodity prices, a lot of people point to Fed policy as the cause.

A: I don’t know why not. It has got to be a factor. It is not the whole thing – you have droughts and temporary movements. But it is a contributing factor. There are drought issues, and supply issues and demand issues like the Chinese diet. But also monetary policy is accommodating demand, I think, worldwide.

Q: Is QE2 working?

A: I would say it is having effects but at what price later on? My view is it is not just about intended consequences, it is about unintended consequences.

Q: How about tapering off QE2?

A: I certainly would. I am for tapering them off. If you can do it in the right way without disrupting the markets, then yes, by June or sooner. But that precondition is a pretty tough precondition – doing it in the right way, not disrupting markets.

Q: Communication?

A: Communication, communication, communication

Q: You have been spending a long time in Washington. Are you planning to come back here when you leave the Fed?

A: If I am asked, I will serve. I love public service.

Q: Would you run for public office?

A: I am not a politician, as my bluntness tends to show.

Q: There is an undercurrent of anti-Fed sentiment among the freshman Republicans. Support for the gold standard, anti-fiat currency… How do you respond to it?

A: I say I understand. I say gold is a very legitimate monetary system. However it will not end crises. It will not end credit bubbles. And it can be just as disruptive as a fiat currency – as an example the Great Depression when gold was hoarded and we had a very serious deflationary experience. Yes, the Fed contributed to it, but also governments contributed to it with their hoarding issues.

Q: But end the Fed?

A: I don’t see that a modern economy would function better without a central bank. We might have stable prices, but that is on average. In the meantime, we would have very strong deflationary pressures and very high inflationary pressures. The average is zero. That is the problem with that. It is not going to solve the world’s problems.

Great job by Gregg Robb of Market Watch in this interview. He provides a very healthy dose of ‘sense on cents.’ At this point in time, I will take the ‘healthy’ and we all can use the ‘sense on cents.’

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own and not those of Greenwich Investment Management. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

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