Without a doubt, the Federal Reserve now faces the most difficult financial and economic climate in our collective memory. And it is increasingly apparent that its options are constrained. Although it is premature to arrive at definitive judgments, it’s nevertheless worth asking whether some of these limitations were unwittingly self-created.

Friday’s market rout, triggered by the one-two punch of an unexpectedly large rise in unemployment and an $11 spike in oil prices, put paid to the idea that the Fed might put through a wee interest rate increase before year end. We didn’t expect anything more than 25 basis points, since the second leg of the credit crunch, this time dragging down regional and local banks, is underway. And Wall Street has not hit bottom either.

But as Wolfgang Munchau tells us in the Financial Times, for the first time in modern memory, a foreign central bank’s stance, in this case, the ECB’s, is limiting the Fed’s scope of action:

In the past, European central bankers tended to follow the US Federal Reserve, often with delay, never perfectly, but generally in the same direction…..The policy response to our most recent financial crisis has been different. While the Fed cut by an accumulated 325 basis points, the Europeans first refused to follow, and they are now moving in the opposite direction…. the ECB is now likely to raise interest rates by 25 basis points next month, and I suspect this could be followed by another rate increase later this year…. This suggests that in terms of global monetary policy, we are in the middle of a shift from a unipolar to a bipolar world. In the past, the Fed’s policy alone used to determine the global monetary policy stance – via the dollar, the global anchor currency. Through long periods of loose monetary policies, including lengthy episodes of negative real interest rates, the Fed contributed directly to the rise in global inflation…. In theory, an independent central bank, under a floating currency regime, can achieve whatever inflation target it wants, no matter what happens elsewhere. In practice, central banks, even tough-talking ones such as the ECB, make compromises. The ECB would not have raised interest rates if the euro’s exchange rate to the dollar had been at $1.70, or if the economy looked as though it were to fall into a black hole… The policy goal of the Fed, meanwhile, appears to be avoidance of recession and minimising distress in the financial system. Price stability, which also ranks as one official goal in the Fed’s mandate, seems to be pursued by means of sanctimonious speeches, rather than policy action. As monetary policy of the world’s two largest economies moves in starkly opposite directions, interesting possibilities are opening up. One is whether the dollar will decline prematurely as a global currency – an issue on which economists are divided. Differential inflation rates could plausibly trigger such a shift. As US inflation rises, more and more countries may unpeg from the dollar to avoid imported inflation. If this trend persisted, the US would risk losing its exorbitant privilege – the ability to live beyond its means thanks to a globally domineering currency.

Before we get to the Fed’s options, to give a fuller appreciation of the difficulty of this situation, Evans Ambrose-Pritchard of the Telegraph, in opposition to Munchau’s view, sees Trichet’s presumed move to tighten as unwise:

ECB chief Jean-Claude Trichet has “signalled” a rate rise in July to combat 3.6pc inflation, much to the fury of Paris, Madrid, Rome, Lisbon and Dublin… The ECB demarche is ominous for the rest of us as well. We may be watching a replay of the Bundesbank’s ill-judged rate rise in October 1987, which sent the dollar into a tailspin and triggered the Black Monday crash. Any tilt to monetary tightening is a dangerous gamble at this delicate juncture. The world is facing an almighty clash between two opposing storm systems. The West is in the full grip of a debt deflation as years of credit abuse come back to haunt it. The East – loosely speaking – is in the blow-off phase of an inflationary boom. Russia, Ukraine, Vietnam and the Gulf are out of control. China has dithered beyond the point of no return. It is they who have repeated the errors of the 1970s, not the West. It will take central banking skills of great subtlety to pilot these seas. Slavish adherence to “inflation-targeting” and other such totemism and pseudo-science will ruin us all… America is going from bad to worse…Fed chairman Ben Bernanke knows that the crunch will tame inflation over time…..But Bernanke is now compelled – against his better judgment – to declare an end to the easing cycle. An interest floor of 2pc has been fixed… The ECB policy shift has already had a perverse effect. By sending the dollar into a fresh dive this week, it triggered a $16 surge in the price of oil over two days. Crude is now moving almost reflexively as a sort of “anti-dollar”, a currency on steroids with eight times leverage. No matter that the global economy is slowing hard. Bad is good for oil in the topsy-turvy world of commodity funds. We are in uncharted waters. The easy trade-off between growth and inflation that so flattered asset prices for a quarter century is over. The monetary lords can no longer shield us from the full consequences of our debts.

Note that despite their polar opposite views on whether inflation or deflation is a bigger risk for developed economies, both Munchau and Evans-Pritchard now see Bernanke as unable to cut rates below 2% due to adverse consequences on other fronts (note that heretofore, going to 1%, as the Fed did in earlier in the decade, had been an option. Indeed, Merrill Lynch economist David Rosenberg had forecast the Fed funds rate at 1% for all of 2009 a mere month ago).

Bernanke has treated the dollar with benign neglect, but now that the oil has become a preferred dollar hedge. Even if oil would fall to $110, it would still put brakes on the economy, and oil above $130 or higher will suck any remaining life out of the economy. The high prices haven’t yet worked their way through to the pump, and the secondary effects, such as the price effects of higher shipping costs, are only beginning to kick in.

But how did the Fed get itself here? There are different ways to frame the problem. We’re of the view that the central bank took rates too low and left them low for too long in the dot-bomb era, and cut too deep, too fast this time. Former Fed economist Richard Alford explains that those decisions were the product of a flawed analytical framework:

One of the interesting aspects of economic policy in the US is a belief that we exist independent of the rest of the world. In the minds of many policy makers, the US is the focus and the rest of world economy is just a stable background. To open the model up to external factors, market imperfections, and quasi-floating exchange rates would increase the complexity of the model and limit the number of policy prescriptions that could be made, so most US economists pretend that the rest of the world does not exist, is stable, or that the dollar will quickly adjust so as to maintain US external balances. It has only been in the past few years that the trade deficit has moved to a level that is clearly unsustainable…. If you look at the difference between gross domestic purchases and potential output, by US consumers, businesses, and government — all are above potential output. The only time in recent memory when the difference between these two measures started to narrow was in 2001 when we were in a recession. One of the things we need to consider is that that US may need to see consumption drop significantly before we can achieve a sustainable position, for example vis a vis the dollar… T]he demand side is fine. Remember, US domestic purchases are still running around 105-106% of potential domestic output. The problem is not the level of demand but rather the composition of demand. Americans are buying too many imported goods and the world is not buying enough of our exports. So we have a growing wedge growing between gross domestic purchases, which is what the Fed really controls, and net aggregate demand, which is defined as gross domestic purchases less the trade deficit. Given the inability or unwillingness of the US to correct the trade imbalance, the Fed has run expansionary monetary policy almost continuously, generating higher levels of domestic purchases so as to keep net aggregate demand near potential output. The Fed did this using low interest rates, which generated asset bubbles, large increases in consumer debt and sharp declines in savings, and also a larger trade deficit.

But there’s another constraint the Fed has taken as a given: recessions are to be avoided, or if that isn’t possible, kept short and shallow. While slowdowns not only do damage, but in our society of tattered social safety nets, do the most damage to the poor and lower income, they may be the least bad of unattractive alternatives. The price of milder recessions has been stagnant average worker incomes.

Economists have come to regard the so-called Great Moderation as a state of affairs that can be engineered to continue in perpetuity. Yet Thomas Palley has argued that that view is flawed and the real source was the erosion of labor’s bargaining power:

The raised standing of central bankers rests on a phenomenon that economists have termed the “Great Moderation.” This phenomenon refers to the smoothing of the business cycle over the last two decades, during which expansions have become longer, recessions shorter, and inflation has fallen. Many economists attribute this smoothing to improved monetary policy by central banks, and hence the boom in central banker reputations…. That said, there are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost…. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth….. The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

Many readers have reacted angrily to statements by economists, particularly those who see themselves as liberal, such as Paul Krugman, that we should be relieved that inflation isn’t becoming embedded, as in generating demands for higher wages that then spiral into even higher costs. They see every day as prices climb that their paycheck goes less far, and the fact that their inability to get compensating pay increases is portrayed as a good thing is galling. Even if they don’t see the broader policy context, they see the consequences full well.

The Fed’s third constraint is what Willem Buiter calls cognitive regulatory capture. Munchau mentioned its symptom: a policy of “minimizing distress in the financial system,” which again creates a bias towards overly accommodative monetary policies. Buiter describes its source:

I believe a key reason is that the Fed listens to Wall Street and believes what it hears, or at any rate, acts as if it believes what Wall Street tells it. Wall Street tells the Fed about its pain, what its pain means for the economy at large and what the Fed ought to do about it. Wall Street’s pain was indeed great – deservedly so in most cases. Wall Street engaged in special pleading by exaggerating the impact on the wider economy of the rapid deleveraging (contraction of the size of the balance sheets) that was taking place. Wall Street wanted large rate cuts fast so as to improve its solvency, not its liquidity, and Wall Street wanted the provision of ample liquidity against overvalued collateral. Why did Wall Street get what it wanted? Throughout the ten months of the crisis, it is difficult to avoid the impression that the Fed is too close to the financial markets and leading financial institutions, and too responsive to their special pleadings, to make the right decisions for the economy as a whole. Historically, the same behaviour has characterised the Greenspan Fed. It came as something of a surprise to me that the Bernanke Fed, if not quite a clone of the Greenspan Fed, displays the same excess sensitivity to Wall Street concerns. The main evidence to me of Fed excess sensitivity to Wall Street concerns are (1) the two cuts in the primary discount rate; (2) the decision to let the clearing bank acting for the primary dealer price the collateral offered by the primary dealer to the Fed in both the TSLF and the PDCF; (3) the modalities of the Bear Stearns rescue, and especially the roads not taken; (4) the proposal that interest be paid on reserves without making this conditional on interest not being paid on required reserves; and (5) the aggressive interest rate cuts since August 2007, and especially the 75 basis points cut on January 21/22 2008.

There are other signs as well. For instance, the Fed has become, to put it crudely, Wall Street’s bitch. It is now assumed that the Fed will not let any meaningful institution fail because they are allegedly too interconnected, as if the US consists of one mega bank rather than individual institutions. But is that true in all cases? Having permitted the banking industry to make its own risk (effectively capital) decisions for derivatives, it handed the industry a blank check in the mid-late 1990s, And the Street will always lever more when it can, since all things being equal, higher gearing is the course to greater profit.

But some animals are more equal than others. Bear Stearns, by virtue of being a major credit default swaps protection writer, could have triggered cascading defaults in the primed-for-disaster credit default swaps market. Like it or not, they could not be cut loose. Yet while even high profile short says Lehman is not going to fail (and the central bank’s latest round of facilities is a big reason why). Yet would a Lehman failure have created a systemic crisis? I’m not convinced that the firm is so deeply or fundamentally involved in the most vulnerable parts of the securities markets as to make that a necessity. But regardless, Lehman, along with its peers, is now the beneficiary of the central bank’s largess.

And the Fed has been way too cautious about insisting that the firms that now benefit from its salvage operations adhere to new, tougher rules. Yes, it’s an election year, which means nothing will happen. But that’s more reason to talk a tough line. The longer investment banks have explicit socialized losses and privatized gains, the harder it will be to roll the new status quo back.

I was similarly distressed to see the timid turns of phrase used by New York Fed president Timothy Geithner in a Financial Times comment, a preview to a speech he will give at the Economist Club of New York today. It grandly talks about things that would be desirable to happen, and too little of regulators being in charge. In fact, the subtext is a reluctance to assert authority, yet in the same article, Geithner (of course) advocates regulatory streamlining in the US with the Fed as the main actor. Some illustrations:

This will require more exacting expectations on capital, liquidity and risk management for the largest institutions that play a central role in intermediation and market functioning. They should be set high enough to offset the benefits that come from access to central bank liquidity, but not so high that they succeed only in pushing more capital to the unregulated part of the financial system….. As we reshape the incentives and constraints for risk-taking in the financial system, we have to recognise that regulation has the potential to make things worse. Regulation can distort incentives in ways that may make the system less safe. One of the strengths of our system is the speed with which we adapt to challenge. It is important that we move quickly to adapt the regulatory system to address the vulnerabilities exposed by this financial crisis. We are beginning the process of building the necessary consensus here and with the other main financial centres.

Notice the litany of reasons to be half-hearted about imposing rules: more capital might go to unregulated players (fine, just prohibit regulated concerns from lending to them); regulations can have adverse outcomes (yes, but any form of insurance is costly, and after what we have been through, light regulation has been an utter disaster); we need the consent of the regulated (since when? Oh, since they bought all the politicians).

I can only hope that new appointments at the Fed will also bring a new tough-mindedness. But that’s probably too much to expect.