Financiers can't borrow short to lend long unless the key borrowing rate is well below medium- and short-term rates. Because the yield curve remains inverted, and money-market credit is frozen, the U.S. monetary base is growing at less than 2 percent. This is very tight money. (Incidentally, this is why no one should be worried about future inflation, even after last week's price-index flare-ups.)
Economic gurus Arthur Laffer and Steve Forbes say the Fed should float its target rate and pump in new money until the yield curve rights itself, money-market credit starts to flow, and the monetary base grows larger. This may sound radical, but it was done after the 9-11 bombings and again last August when the first credit-crunch episode developed.
Back in the 1980s, Paul Volcker floated the fed funds target in order to withdraw liquidity and halt inflation. Not only did Volcker let markets set the funds rate, when he went back to targeting the rate he tolerated a 50 to 100 basis point band, rather than a pinpoint price.
Pouring in new reserves and moving to a floating funds target is exactly the right move. It could be done for a short period until the crisis clears up, or it could be a major monetary reform. For the inflation hawks out there, the added liquidity can always be mopped up if upward price pressures develop.
Who knows if the Bernanke Fed is creative enough to take this approach. Many observers believe the former Princeton economist is lacking in leadership, that he is merely a consensus-taker. James Pethokoukis of U.S. News and World Report is even citing a number of Washington and Wall Street sources who think Bernanke is a one-term chairman. He is not getting the job done. Cynics believe the Fed is too full of academic bureaucrats and that it needs some real-world, hands-on policy advisors who have gotten their fingernails dirty in the day-to-day workings of the markets.
New economic data on strong retail sales, rising industrial production and increasing employment say the Goldilocks economy is doing reasonably well in spite of the deep housing recession and sub-prime virus. But Bernanke must think outside the box if he's to keep the future economy on track -- and keep his job, too.