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The Fed Might Have Painted Itself into a Corner

June 12, 2009

Tags The FedFinancial MarketsGlobal EconomyInterventionism

A growing concern for Fed policy makers is a weakening in the US dollar against major currencies. The price of the euro in US-dollar terms climbed from a low of $1.27 in November last year to around $1.41 in May and $1.43 in early June — an increase of 12.6% from November. The major currencies dollar index fell to 78.89 in May from 82.3 in April — a fall of 4.1%. If the declining trend in the US dollar were to consolidate, this could cause foreign holders of US-dollar assets to divest into non-dollar-denominated assets and precious metals. This in turn could spark another financial crisis.

For instance, on June 6, 2009, Russia's President Dmitri Medvedev said that American financial policy had made the dollar an undesirable currency for reserves held by central banks.

Also China — the largest holder of US-dollar reserves — has voiced its misgivings with the Fed's massive money pumping, which is seen as an important reason behind the recent weakening in the US currency. Note that in March, China's US-dollar reserves stood at $1,953.7 billion — an increase of 2.2% on the month before. The value of the China's holdings of US Treasury securities was $767.9 billion in March against $744.2 in February and $490.6 billion in March last year.

If the US dollar weakens further, Fed policy makers will be forced to slow down monetary pumping in order to placate foreign investors. A visible strengthening in commodity prices is also likely to put pressure on the Fed to slow down the money printer. In May, the CRB commodity price index shot up by 13.8% from the month before.

Some harsh critics of the Fed, such as John Taylor (the inventor of the Taylor rule), are of the view that the Fed should already be embracing a tighter stance to prevent the repetition of the interest-rate policy of Greenspan's Fed, which was kept at a very low levels for too long. According to John Taylor, Greenspan's low-interest-rate policies had been a major contributing factor for the present economic crisis. (Greenspan had lowered the federal-funds rate from 5.5% in January 2001 to 1% by June 2003 and kept the rate at 1% until June 2004. Note that currently the federal-funds rate is between zero and 0.25%.)

There is almost complete agreement among various commentators that the massive monetary pumping by the Fed since September last year was necessary to prevent a plunge in aggregate demand.

As a result, it is held, the Fed has prevented the economy from falling into a severe recession. According to this way of thinking, the increase in money supply strengthens the demand for goods and services, which in turn strengthens the economy. A stronger economy in turn feeds back into the demand and this strengthens the economy further.

Following this logic, whenever the economy is starting to gain strength and can stand on its own feet, there is no need any longer for all the pumped money. In fact keeping all the pumped money can be detrimental to the economy's health. (Keeping all the pumped money can only lay the foundation for various distortions and a higher rate of inflation some time in the future — so it is held.)

It follows that, once it has been established that the pumped money has managed to place the economy on a healthy growth path, the pumped money can be safely removed without any bad side effects whatsoever. (Again, according to this way of thinking, money pumping is required as long as the economy cannot stand on its own feet.)

The Illusory Economic Recovery

Most Fed officials and various economic commentators are of the view that the US economy might be rapidly approaching a stage where it is possible to take out a large chunk of the recently pumped money without causing any harmful side effects in regard to economic activity.

Seasonally adjusted construction spending increased by 0.8% in April after rising by 0.4% in March. Pending sales of previously owned homes shot up by 6.7% in April, the biggest monthly gain since October 2001. Manufacturing activity also shows signs of strengthening. The ISM index rose to 42.8 in May from 40.1 in the month before. The new orders component of the ISM jumped to 51.1 in May from 47.2 in April. It seems that the economy is on its way to standing on its own feet.

What most commentators and Fed policy makers don't tell us is that monetary pumping has given rise to various bubble activities. These bubble activities are supported by real savings that have been diverted from wealth generators by means of pumped money. Also note that the pumped money has prevented the removal of various old bubble activities. Hence, contrary to popular thinking, the massive money pumping has actually weakened the economy's bottom line.

If the Fed were to start taking some of the newly pumped money from the economy, i.e., to curb the money-supply rate of growth, this would hurt various old and new bubble activities. It would set in motion an economic bust. (Remember, bubble activities are not self-funded; they require money "out of thin air," which is employed to divert real savings to them from wealth generators.)

Summary and Conclusions

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A major concern for Fed policy makers is a visible weakening in the US dollar against major currencies. If the Fed were to allow the dollar to fall further, the US central bank runs the risk that major holders of US-dollar assets will divest to nondollar assets. This could push long-term rates and mortgage rates higher, thereby igniting another crisis. If, in order to defend the dollar, the Fed were to start taking some of the newly pumped money from the economy, i.e., to curb the money supply rate of growth, this will hurt various old and new bubble activities and set in motion an economic bust. Even if the Fed were to decide to tighten its stance just slightly, given the current strengthening in the growth momentum of economic activity, this could visibly weaken the growth momentum of monetary liquidity, thus posing a threat to the stock market. It seems that the Fed might have painted itself into a corner.

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