Loose Steering Wheel?

Monetary Policy
for Dummies

Because homes are overwhelmingly purchased with borrowed money (more than 90%, to be exact), to understand the housing market's prospects, you have to have a clue about how credit works. In turn, that requires at least a passing acquaintance with the credit market's overseer and regulator, the Federal Reserve (still reading? Good!).

In that spirit, here is a primer on what the Federal Reserve does.

If the economy is a car, the Federal Reserve is the driver.

When the Fed wants the car (economy) to speed up, it hits the accelerator by lowering short-term interest rates and expanding the money supply. When it wants the economy to slow down, it applies the brakes by raising rates, and contracting the supply of money.

The dilemma facing the Fed now is that many parts of the economy -- housing, the credit markets, Wall Street -- are suffering and badly need a shot of gas (actually, a sixth or seventh at this point). Meanwhile, runaway energy and commodity prices require that the Fed hit the brakes.

What to do? Exactly.

What's new in the last couple years is all the exotic financial instruments and non-bank entities that operate outside of the Fed's regulatory authority. To pick just one example, much of the money that funded mortgages at the height of the credit bubble came from creatures of Wall Street that completely sidestepped Fed and banking requirements. So instead of being limited to maximum leverage of roughly 20:1, like regulated banks, some of these entities took on leverage approaching 30:1, 40:1, or more.

Leverage primer: if you buy something for $1 with a penny of your own money and 99 cents of debt, and it goes up to $1.01-- you've doubled your "investment"! Unfortunately, if the item drops to 97 cents, you're wiped out (and then some). Add 8 zeroes and you understand what happened to Bear Stearns.

Big Fish . . Bigger Pond

The other new development is the shrinking U.S. role in the world economy, relatively speaking. Instead of a giant amongst pygmies, the U.S. is destined to become merely first among equals (see, "The Rise of the Rest," by Fareed Zakaria). That's the case not just with respect to the European Union, but also the fast-growing BRIC countries (Brazil, Russia, India, and China).

Both of these developments have significantly weakened the Fed's control over the U.S. economy.

To return to the car metaphor, it turns out that speed isn't the only thing that's important -- so is steering. As Ralph Nader might put it, if the steering wheel comes off in your hands. . . you're not safe at any speed.