The Fed Might Have Painted Itself into a Corner

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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
), 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.

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.)

and Conclusions

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.

This article
originally appeared on

13, 2009

Shostak [send him
] is an adjunct scholar of the Mises Institute and a frequent
contributor to He is chief
economist of M.F. Global.

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