Thursday, January 26, 2012

In defense of the Fed

Instead of being one of another million bloggers discussing the Fed's decision to hold interest rates low until 2014, I wanted to write about the Fed's role in the conduct of monetary policy. There has been a lot of criticism of the Federal Reserve from Republican quarters during this presidential primary season. Much of it stems from the likes of Ron Paul. Marketwatch reports that:
Compounding the criticism of the Fed is the role the central bank has played in the political career of Ron Paul.

“Paul’s position hasn’t changed in decades. He’s opposed to the Fed as an institution, preferring a gold standard and free banking,” said Michael Bardo, an economic professor at Rutgers University.
Other Republican presidential candidates have been just as hostile:
Texas Gov. Rick Perry started the attacks off by threatening bodily harm to Federal Reserve Board Chairman Ben Bernanke and accusing him of treason.

Front-runner Mitt Romney has since said he would fire Bernanke. Former House Speaker Newt Gingrich also said he would fire Bernanke and went further to propose a commission to examine returning the U.S. to the gold standard. And Texas Rep. Ron Paul has reveled in his unwavering stance of simply ending the Fed.
Why the Federal Reserve? Why now? According to Marketwatch:
[Mark] Calabria [director of financial regulation studies at the Cato Institute] thinks the Republicans anger might coalesce behind legislation to end the Fed’s twin goals of low inflation and low unemployment in favor of a single low-inflation mandate.

In praise of the dual mandate
Libertarians such as Ron Paul have long been advocates of abolishing the Federal Reserve in favor of the market discipline of a gold standard. Notwithstanding my opposition to the gold standard (see my previous comments here and here), consider what changing the Fed's dual mandate to a single anti-inflation mandate might mean.

First of all, you get the ECB, which until Draghi era began, stood aside while Europe burned.

In addition, good quants know that optimizing a system to a single objective function without considering other factors can lead to perverse results.

For instance, investors generally construct portfolios to maximize their risk-adjusted returns (however that`s measured), which is comparable to the opposing objectives of the dual mandate of the Federal Reserve. What would happen if they were to move to a single mandate by trying to either just maximize expected return or minimize risk?

If they were to maximize expected return, their portfolio would be two holdings, one long and one short. If they were to minimize risk, then the portfolio would be all cash.

Does that kind of portfolio make sense? I have frequently disagreed with many decisions taken by the Federal Reserve, but the idea of either abolishing the Fed or to move it to a single mandate sounds ludicrous to me.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Whisperer said...

No nation should ever turn over the right to print it's currency to a consortium of private banks.

Thomas Jefferson and Andrew Jackson's comments on this regard hold just as true today as they did when they were made.

The Federal Reserve should be abolished.

Joe "Truth 101" Kelly said...

You may not want to post this comment as my following doesn't look like the following you'd want inhabiting your comment section Mr. Hui.

I just wanted to say I appreciated this and your other posts. Always well written and having good information. I wish you continued success.