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Markets ‘Get It’…Central Banks Don’t

February 19, 2010

The FOMC, apparently not realizing that it was the anniversary of the American Recovery and Reinvestment Act yesterday, saw it fit to begin raising the discount rate:

While the Federal Reserve had signaled its intention, the timing was a surprise, coming between scheduled policy meetings. The announcement was made after markets had closed in New York Thursday, and the Fed’s carefully worded statement emphasized that it was not yet ready to begin a broad tightening of credit that would affect businesses and consumers as they struggled to recover from the economic crisis.

Now what does Ben Bernanke have to say about 1931, the last time the discount rate was raised during a period of prolonged unemployment?

On October 9 [1931], the Reserve Bank of New York raised its rediscount rate to 2-1/2 per cent, and on October 16, to 3-1/2 per cent–the sharpest rise within so brief a period in the whole history of the System, before or since (p. 317).” This action stemmed the outflow of gold but contributed to what Friedman and Schwartz called a “spectacular” increase in bank failures and bank runs, with 522 commercial banks closing their doors in October alone. The policy tightening and the ongoing collapse of the banking system caused the money supply to fall precipitously, and the declines in output and prices became even more virulent. Again, the logic is that a monetary policy change related to objectives other than the domestic economy–in this case, defense of the dollar against external attack–were followed by changes in domestic output and prices in the predicted direction.

Of course, markets around the world were not particularly joyful following the announcement:

Hong Kong’s Hang Seng stock index led decliners, diving 2.6 percent to 19,894.02 while Japan’s Nikkei 225 stock average dropped 2.1 percent to 10,123.58.

South Korea’s Kospi declined 1.7 percent, India fell 1 percent and Indonesia dropped 0.5 percent.

Singapore’s stock measure retreated 0.9 percent despite an increase of the government’s 2010 economic growth forecast to between 4.5 percent and 6.5 percent from 3 percent to 5 percent.

Europe fared better, and the US finished up very weakly today…which is odd, since we are getting the wish of pundits claiming that China needs a stronger yuan. Judging by how much harm “trade imbalances” are apparently doing to the world economy, you would think the markets in Europe would be a little bit more enthusiastic?

Update: New York Fed president William Dudley repudiates me. Unfortunately, however, he equates easy money with low interest rates:

The discount rate increase “is not at all a signal of any imminent tightening” in monetary policy, and the Fed’s commitment to keep rates very low for an extended period “is still very much in place,” Dudley said.

I don’t know where these officials are getting this, but the Fed doesn’t have to “imminently tighten”…they already allowed monetary policy to tighten. The economy needs monetary policy to “imminently loosen” so we can close the very depressing 8-10% output and productivity gap…


Hat Tip: Bill Woolsey.

As Paul Krugman says, “We may have to start calling the Fed chairman Bernanke-san, after all.”

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