Inflation and Dodd-Frank: What Were They Thinking?
Life + Money

Inflation and Dodd-Frank: What Were They Thinking?

Campaigning against Jimmy Carter in 1980, Ronald Reagan famously asked: Are you better off today than you were four years ago? Now we ask: Are our financial markets safer today than they were four years ago?

The Obama administration says we are, but as Americans see the price of gasoline skyrocketing and inflation seeping into countless other necessities of life, they aren’t so sure. The most recent reading of consumer sentiment swooned in March to the lowest reading since November 2009. The survey showed Americans increasingly worried about future inflation.

For most of us, successful financial regulation means keeping the economy on track, our savings secure and the dollar sound, which means, most importantly, reining in inflation. The problem is, the people in charge of curtailing inflation are the very ones making its resurgence a near certainty. 

The threat to our financial system is not hidden in the vault of some bank or on the trading floor of the Chicago Board Options Exchange – it is contained in the excess liquidity being created by the Federal Reserve’s quantitative easing program (QE2), which has now piled some trillion dollars onto that agency’s balance sheet.

Reviewing the financial crisis, politicians and voters wondered why regulators failed to see and abort the subprime mortgage threat. As banks issued billions of dollars in loans backed by overpriced properties to people with no verifiable income, as financial firms bundled those unworthy mortgages into securities overrated by Moody’s and Standard and Poor’s, and as the thread of responsibility stretched beyond the breaking point, the Fed and officials at the Treasury looked the other way.

In response to the collapse, Congress passed the massive Dodd-Frank regulatory overhaul, which creates gobs of new regulations, committees and rules but does little to actually prevent the next crisis. That takes insight and wisdom – things  not traded on any exchange or written into any bill. 

Around the world, regulators and analysts increasingly blame the Fed for soaring commodity prices: the International Monetary Fund reports that global food prices were up 61 percent from their most recent low in December 2008. Such increases are driving poor countries to the breaking point. Here at home, criticism has been dulled by a surging stock market, arguably an intended side-effect from QE2, and a recovering economy. The rising cost of living has been masked by low interest rates and the still-depressed housing market, both of which conspire to keep inflation reports benign.

Who is overseeing (and protecting us) from this pile-up of liquidity and inflation? That would be the job of the Financial Stability Oversight Council.  The Treasury’s website says, “As established under the Dodd-Frank Act, the Financial Stability Oversight Council (FSOC) will provide, for the first time, comprehensive monitoring to ensure the stability of our nation's financial system. The Council is charged with identifying threats to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States financial system.”
How is the FSOC going about that charge? The Treasury reports that the council will 1) facilitate regulatory coordination, 2) facilitate information sharing, 3) designate nonbank financial companies for coordinated supervision,  4) designate systemic financial market utilities and systemic payment, clearing or settlement activities, 5) regulate stricter standards (for the largest, most interconnected firms), 6) break up firms that pose a “grave threat” and 7) recommend Congress close specific gaps in regulation. How will the council communicate about emerging threats? It is required to report to Congress annually.
The legislation was drafted as a rebuke to the financial sector and not as a blueprint for serious financial market reform.

Are you feeling better already? Does it disturb you that there is nary a word about monitoring inflation, or asset bubbles? Are you comforted that the council’s ten voting members include the heads of the SEC, the Fed, the Consumer Financial Protection Bureau, the FDIC, the Commodities Futures Trading Commission, the Federal Housing Finance Agency, the National Credit Union Administration Board, the Comptroller of the Currency, a random insurance person and the Secretary of the Treasury as chairman? Do we imagine that all those folks will meet frequently, will see eye-to-eye (for the first time in history), and agree on measures necessary to address imbalances in the economy? How do you feel about the Easter Bunny?
Consider that at the most recent meeting in March, which lasted slightly over two hours, the council heard presentations on designating financial market utilities – the entities that clear and settle transactions -- as systemically important, and proposed regulations for implementing the Freedom of Information act. That should reassure investors.

It will only be in hindsight that we learn the shortcomings of Dodd-Frank. We know now that the legislation was drafted as a rebuke to the financial sector and not as a blueprint for serious financial market reform. The bill adds new layers to a regulatory scheme that was denounced for its unworkable complexity and fails to anoint a workable “overseer” that could actually stand in the halls of Congress and shout: “The stock market is ripe for a crash! Property values are unreasonable! Interest rates are too low!” Alan Greenspan tried it once, hinting that stock prices were the product of “irrational exuberance.” He was demonized for his trouble; perhaps that scorching prevented him from reining in the dot-com bubble, or the subprime surge.

It is said that Fed Chair Bernanke is obsessed with Japan’s ‘lost decade’, and as a result worries more about deflation than inflation. He may prove too focused on the rear view mirror -- in this case a mirror that should warn “inflation may be closer that it appears.”

Related Links:
ADB Warns of Inflation (The Wall Street Journal)
Survey:  Inflation to Jump 200% in 2011 (Time)
Treasuries Yields Up on Inflation Worry, Tightening Fears (Reuters)