The Fed's Futile Effort To Bail Out Obamanomics

The Fed's Futile Effort To Bail Out Obamanomics
Charles Kadlec
9/14/2012

In what can be viewed as a desperate effort to bail out the failed economic policies of the Obama Administration, the Federal Reserve this week committed to purchasing $40 billion a month of mortgage backed securities for an unlimited time and to keep interest rates artificially low until at least mid 2015.  By so doing, the Fed has embarked upon a course that invites higher inflation, falling living standards, and a global financial crisis.

The Federal Open Market Committee's (FOMC) official statement, released Thursday after the conclusion of its meeting, pays lip service to price stability, which it defines as an increase in the price level of 2% a year, or a 33% devaluation of the dollar over the next 20 years. However, the Fed also left little doubt that for the foreseeable future, it will print money in an effort "to support a stronger economic recovery."

The fundamental problem is the Fed's policy stance is internally incoherent.  Stabilizing the value of the dollar would require the Fed to provide as much, or as little, money as the world demands at a stable price level.  In other words, price stability requires the quantity of money to be the variable.

However, the Fed has chosen the opposite policy.  Now, the quantity of money will increase at a fixed, $40 billion a month, which, by necessity means any change in the demand for dollars that does not precisely match the increase in the dollar's supply will produce a change in the price of the dollar. In other words, the Fed's new policy will lead to unstable prices.

The most likely direction of instability will be higher inflation.  First, the Fed is increasing the supply of money relative to the demand for dollars in an explicit effort to lower interest rates and spur consumption.  Too much money relative to the demand for money cheapens the dollar and leads to higher prices.

Second, this process feeds on itself.  By increasing the risk of inflation, the Fed's policy has made holding dollars more risky which produces a fall in the demand for dollars  – individuals and businesses alike seek to avoid holding any asset whose value is in decline.  A fall in the demand for dollars in the face of rising supply adds fuel to inflationary pressures.

This process has started already.  In his remarks at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming on August 31, Fed Chairman Ben Bernanke signaled the Fed was likely to decide on another round of quantitative easing at the FOMC meeting just ended. Between August 30 and Tuesday, the value of the dollar in terms of gold fell 4.5%.  It then fell an additional 2.2% on Thursday, the day the Fed announced its next round of quantitative easing.

Over that entire period, the dollar also fell 3.7% against the struggling euro, and the price of oil rose nearly 5%. Price changes of this magnitude in so short a time point directly to a fall in the demand for dollars and higher inflation in the months ahead.  Only a shock to the global financial system which would increase the demand for dollars by triggering a flight into the dollar can reverse these inflationary pressures.

Although the risks of inflation are all too real, the supposed benefits of the Fed printing money and keeping interest rates low are highly questionable.  A just published Federal Reserve Bank of Dallas working paper by William R. White, entitled:   " Ultra Easy Monetary Policy and the Law of Unintended Consequences" concludes the negative consequences of the sort of quantitative easing the Fed has just embraced will likely outweigh any short term benefits:

"…the capacity of such (ultra easy) policies to stimulate 'strong, sustainable and balanced growth' in the global economy is limited.  Moreover, ultra easy monetary policies have a wide variety of undesirable medium term effects – the unintended consequences.  They create malinvestments in the real economy, threaten the health of financial institutions and the functioning of financial markets, constrain the 'independent' pursuit of price stability by central banks, encourage governments to refrain from confronting sovereign debt problems in a timely way, and redistribute income and wealth in a highly regressive fashion.  While each  medium term effect on its own might be questioned, considered all together they support strongly the proposition that aggressive monetary easing in economic downturns is not a 'free lunch'."

Of course, we have been suffering just these consequences from a too-easy Fed for the past dozen years.  Since 1999, the Fed, first under Alan Greenspan, and then under Ben Bernanke, sought to manage the U.S. economy by manipulating interest rates and the value of the dollar.  In addition, Presidents George W. Bush and Barack Obama have pursued a weak dollar policy in hopes it would stimulate job creation in the U.S.

Instead, easy money and the weak dollar have crushed the middle-class with more than a decade of below average growth and falling living standards.  Since 1999, the dollar has been devalued more than 80% against gold.  Economic growth has averaged a paltry 1.7% a year – the worst 12 years since the 1930s.  The Fed's easy money policies during the middle of the decade contributed directly to speculative bubble in real estate and the financial crisis of 2008.  And this week, the Census Bureau reported real median household income in 2011 fell for the fourth consecutive year in a row, and is now down 8.9% from where it stood in 1999.

Expect more of the same from the Fed's latest pursuit of the hubris of central planning over its vital role of providing domestic and international markets with a strong and stable dollar.  The run-up in the price of gold and oil in just two weeks indicates any short-term increase in demand will be offset quickly by higher prices and falling real wages and profits.  The rush into gold, which provides no economic benefit other than to protect its holder against bad monetary policy, also indicates the malinvestments have already begun. The yield on the 10-year Treasury bond has begun to creep up.  And, the rush to hedge against the debauchery of the dollar sets the stage for the next bubble and plants the seeds of the next financial crisis.

What is missing is a robust debate over monetary policy in the Presidential campaign.  President Obama through his silence implicitly endorses the Fed's move in hopes it will somehow bail out the economy from his administration's failed economic policies. Republican Presidential Nominee Mitt Romney criticized the Fed's move as evidence that the economy is not improving, but he has yet to offer a hard dollar alternative to the failed soft dollar of the past dozen years.

The Republican platform calling for a gold commission now appears prescient.  The time is past due to restore a rules based monetary policy that will guarantee the value of the dollar and insure the independence of the Fed.  The question is: does Governor Romney have the wisdom and courage to embrace monetary reform as a central plank in his own bid for the Oval Office.

http://www.forbes.com/sites/charleskadlec/2012/09/14/the-feds-futile-effort-to-bail-out-obamanomics/