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Given the weak state of the u.s economy’s

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Unformatted text preview: Given the weak state of the U.S. economy’s recovery (as of August 2010), there seems to be little inflation risk in the short run. Real household spending is growing only at an annual rate of 1-2%, household savings have gone up to 6% of disposable income, corporations are sitting on piles of cash, and banks’ lending standards to households and small businesses remain tight. If anything, the main worry seems to be one of a further decline in aggregate demand and price deflation. What is the big deal if in a jobless environment with deflationary risk, such as the one we are in, the Fed is constrained somewhat in its interest-rate decisions? 84 This is, however, a massive problem for the future. Because interest rates are the most important prices to be set in the economy, any systematic error in interest rate policy can distort capital allocation and lead to asset price bubbles. Banks and corporations are both sitting on a lot of cash. Guided by the invisible hand of low interest rates, they might start deploying the cash for investments, and collectively build a heap of overinvestment, only to fall off the overinvestment precipice eventually. In fact, the housing boom until 2006 also fed off low interest rates for many years. Yes, we do not have significant lending and investments happening now, but when the pendulum swings back to growth, will the Fed balance sheet be in a shape to correct the stimulus-induced investment boom and inflation, and do so in a timely fashion? Without doubt, traditional monetary policy would be much more straightforward without more than a trillion dollars worth of interest-rate sensitive assets on the Fed’s balance sheet. Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, said in a recent speech that their estimations suggest that even 20 years out, the Fed is likely to have approximately $250 billion of MBS holdings. 44 This is because any unwinding of the MBS must be done sufficiently slowly to avoid a significant price impact. At present, attempts to unwind the securities in large chunks are likely to be met by anemic private demand. Hence, the Fed’s holdings of MBS, Agencies, and Treasuries will likely remain above $1 trillion one-to-two years hence, when interest rates may need to be raised again. This quandary over raising rates creates undesirable regulatory uncertainty. 6.4. The Dodd-Frank Act, the Fed, and Fannie-Freddie 45 The fallout for the Fed from its emergency actions in dealing with the failures of Bear Stearns and in particular AIG has not exactly been friendly. For instance, Congressman Ron Paul wanted to End the Fed in his bestselling book with that title and in a more softened form in the Grayson-Paul amendment that was introduced in 2009, which would have subjected Fed decision making to audits and second-guessing by Congress. Somewhat fortunately, the Dodd- Frank Act of 2010, the biggest overhaul of financial regulation in the United States since the 1930s, mutes the Paul proposals. 1930s, mutes the Paul proposals....
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Given the weak state of the U.S economy’s recovery(as of...

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