Thursday, June 5, 2008

The Fed was wrong, and knows it

The Fed has done lately a few moves that were out of the ordinary lately, and has been heavily criticized for it. It seems to start acknowledging now that it was wrong. Bernanke is dropping hints that interest rates will go up sooner than later due inflationary pressures. But the biggest head turner was the episode with Bear Stearns.

Now, Richmond Fed president Jeffrey Lacker acknowledges in a speech that bailing out Bear Stearn is counterproductive, as it has radically changed the expectations of the financial sector. You do not need to be a genius to figure that out, as much of banking theory is centered exactly on this concept and its related moral hazard issues, but it is nice to see an official concede he messed up.

This is the perfect opportunity to undo the damage. Acknowledge now big time that it was a mistake, and find some way for the Fed to commit itself not to do this in the future. For example by having some heads roll.


Anonymous said...

You are a bit harsh on the Fed here. They are acknowledging they made a mistake, reward this by not letting heads roll.

Economic Logician said...

Vilfredo, this is the whole point. You want the Fed to be able to signal a regime change, that the weak regular has been replaced by a strong one. Hence the need for replacement.