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Obamacon Doves vs. Hard-Money Heartland Hawks

A Commentary by Lawrence Kudlow

Sunday, May 02, 2010

President Obama has appointed three new doves to the Federal Reserve Board, thereby taking command of the nation's central bank. But there's a split developing inside the Federal Reserve System: The Reserve Bank presidents, appointed by their own district boards of directors, are increasingly likely to wage a battle royale against the central-bank headquarters in Washington and its free-money, ultra-easy policies.

The new Obama appointees include Janet Yellen, president of the San Francisco Fed, Peter Diamond of MIT and Sarah Bloom Raskin, the top Maryland state banking supervisor -- who blames Wall Street greed for much of the financial crisis.

Now, Yellen is a highly credentialed and respected former Clinton administration economist. But the new Fed vice chair is also a devotee of targeting the unemployment rate as a key monetary-policy gauge. The Keynesian idea here is that too many people working cause inflation. So with a 9.7 percent unemployment rate, she can be expected to back Fed head Ben Bernanke in his quest for continued free money, with the other new doves following suit.

Make no mistake about it. These appointees (along with Daniel Tarullo, an earlier Obama appointee and another dove) make for an easy-money, pro-regulation Fed. As for monetary soundness, price stability and a reliable King Dollar, these highly credentialed academics won't pilot us there.

California economist Scott Grannis recently blogged about "easy Fed, strong gold." The yellow metal, which has proven to be the best indicator of currency confidence, continues its upward trend against the dollar, and for that matter against the euro and Japanese yen. Grannis also has been writing about the surge in commodity prices, which are marching onward and upward in a V-shaped recovery. Grannis, in other words, is tracking the appropriate indicators.

Many supply-siders, including myself, believe that commodity prices in the open market are the best measures of whether money is too tight or too loose. But no one on this new Obama monetary team will be paying much attention to gold and commodities. They believe in the so-called Phillips Curve tradeoff between inflation and unemployment, despite the breakdown of that model back in the 1970s, when both measures rose together, and for most of the 1980s and 1990s, when both measures fell together.

Indeed, more people working more productively will create more economic growth to absorb the money supply and maintain very low inflation. On the other hand, the $2 trillion Fed balance sheet -- which embodies the creation of a massive new volume of the high-powered monetary base, to draw on Milton Friedman's analysis -- sets the stage for too much money chasing too few goods and a steady depreciation of the dollar.

In this scenario, enter one Thomas Hoenig, head of the Kansas City Fed.

Hoenig is a rising monetary superstar who has dissented at each of the last three Fed open-market meetings. He believes money is too loose, and says that if this continues, we risk a new financial bubble that ultimately will come to no good end. I believe Hoenig's warnings are right on target.

At its meeting this week, the Fed chose to ignore clear signs of a stronger-than-expected V-shaped recovery, along with the bubbling-up of commodity prices and double-digit gains in the producer price index. This is a high-risk strategy. It points to no plan for exiting the zero-interest-rate policy that continues to govern long after the financial and economic emergency has passed.

My own view is that we need a dose of what I call cowboy monetarism. By that, I mean the Fed should surprise Wall Street traders with unexpected policy restraint in order to keep them from taking excessive risks in their financial dealings. Like the cowboys of the Old West, who would act in their own defense at a moment's notice, the Fed should not be afraid to pull the trigger on some small restraining moves now to prevent new financial bubbles and an outbreak of inflation down the road.

Wall Street economist Mike O'Rourke criticizes the Fed for cutting and pasting the same predictable phrases from the same predictable policy at each successive Fed meeting. The Fed basically did it again this week. And this is exactly the same mistake it made during the 2002-05 period, when the last bubble was born.

Some small restraining signals now might save us a lot of aggravation later. But the Obama doves are going to resist this approach.

The downside of this stubborn adherence to failed monetary theory may not only put the soft-money Obamacon doves at war with the hard-money Reserve Bank hawks, it could do great damage to hopes for a recovery in American prosperity in the years ahead.

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