the Fed’s Open Market Committee

The Fed’s Open Market Committee, which determines the Fed’s interest rate policy, consists of 12 members.  Seven are appointed by the president, five are taken on a rotating basis from among the heads of the 12 regional Federal Reserve banks.  The regional bank heads are selected by the boards of directors of their respective banks–typically prominent local businesspeople–and approved by the Fed’s board of governors.  The Huffington Post has the best synopsis I’ve seen.

the Frank proposal

Barney Frank, the senior Democrat on the House banking committee, is trying to change that.  According to Bloomberg, Mr. Frank wants the five regional banker votes eliminated.  They would be replaced by four appointees chosen by the president.

Why the change?  In Mr. Frank’s opinion, the current procedure isn’t “democratic” enough, because the regional Fed chiefs aren’t vetted by publicly-elected officials.     …and, oh, by the way, Mr. Frank also disapproves of the way the regional Fed chiefs vote.  They’re too worried about inflation (that is, about sound money).  Looser money policy than they’re willing to tolerate might help spur job growth, he thinks.  Presumably political appointees would vote as they’re told to by their political bosses.

Basically, then, Mr. Frank’s goal is to induce a significant level of inflation in hopes of creating jobs.

This is a bad idea.

The one sure effect of a higher level of inflation would be to weaken the dollar.  That would doubtless frighten the foreigners who own huge amounts of Treasury bonds, causing them to demand higher coupon rates before they roll over their holdings as existing bonds come due.  In fact, the last time the US was in this situation, during the Carter administration, foreigners flat out refused to buy dollar-denominated bonds from the US.  They not only demanded higher rates; they demanded to be repaid in harder currency, like the D-mark, before they would lend Washington money.

During the same period, companies stopped investing in new plant and equipment.  Rising inflation made it too hard to figure out whether these investments made any economic sense.  Then there was the mammoth recession of 1981-82, when interest rates rose above 20% as Paul Volcker set about putting the inflation genie back in the bottle.  At the time, it was conventional wisdom that this process caused so much economic hardship for the country that no one would advocate reintroducing inflation into the economy ever again in our lifetimes.

So more inflation = high interest rates + weak currency + economic slump = higher unemployment + personal bankruptcies + business failures.

Would anyone want that?

But here’s Mr. Frank, who lived through the pain once–and who should know better, eager to take the risk of this happening again.

Why, Barney?

It may be that Mr. Frank, as a Democrat in a legislative chamber controlled by the Republicans, figures he can make a political statement without any risk, because no bill of his will ever pass the House.

Even so, the pro-labor/anti-business tone of his proposal invokes memories of an era of class struggle in the US that ended half a century ago.  It may resonate with voters in their seventies or eighties; anyone younger will likely just regard the Frank bill as I do–irresponsible and dangerous.

investment implications

Higher inflation means lower bond prices and lower price-earnings multiples for stocks.  Any threat to the independence of the central bank will create big problems financing government debt.  It may not be foreigners who balk at buying Treasuries, either.  Historically, domestic bond investors have been the first to react when government policy threatens the value of their investments.

My guess is that the Frank bill is DOA.  Given that far-right Republicans also want to lessen the independence of the Fed, however, I think the situation warrants continuing monitoring.