Is the Fed Hurting the Dollar in the Long-Term?

By now, everyone is surely familiar with the measures that the Federal Reserve Bank and US Treasury (under the auspices of the US government) have unveiled to blunt the impact of the credit crisis. The accompanying debate, regrettably, has dwelled on matters of efficacy; in other words, are such measures adequate to stimulate the economy and prevent it from sliding into long-term recession? Only a few analysts have taken to pondering the long-term monetary implications of such policy-making. This is to be expected, since those who call for restraint have always been outnumbered by those favoring bold (and expensive) action. Besides, the Fed has always had critics, namely those who advocate a return to the gold standard. But perhaps this time is different. In recent memory, the stakes have never been so high, and the global economy has never been so imbalanced. Accordingly, the Fed and the Treasury must be careful that in treating the economic crisis, they don’t inadvertently damage the very foundation of the US economy.

History of the Fed

Without boring too deep into the history of the Federal Reserve, suffice it to say that it differs from a normal Central Bank in that its first priority is not necessarily to guard against inflation. In fact, the Fed was created in order to facilitate -rather than counter- inflation, albeit in moderation. "Under the Fed’s enlightened stewardship, the currency would become ‘expansive’. Accordion-fashion, the number of dollars in circulation would expand or contract according to the needs of commerce and agriculture." To this day, the Fed’s mandate remains slightly murky; it is charged both with maintaining full employment and with managing inflation. Not only do these aims often conflict, but also the Fed’s notions of inflation are often dubious. For example, its approach to measuring inflation rests on consumer prices, rather than on the money supply. Two years ago, it even went so far as to stop publishing data on M3, which most experts reckon is the "most-inclusive measure of the growth of the U.S. money supply." While the Fed argued ostensibly that such data was no longer relevant, some commentators believe its true motive was to downplay the risks that its easy monetary policy would contribute to long-term inflation. Meanwhile, the Fed has also refrained from utilizing even an informal inflation target. This contrasts with the European Central Bank, which uses 2% as an approximate guide.

Ben Bernanke, current Chairman of the Fed, is known for his especial complacency with regard to inflation. In fact, he earned the nickname "Helicopter Ben" by joking that if need be, Dollars could be dropped from helicopters in order to stimulate the economy. Bernanke has received backing in this view from prominent academics, including advisers to current president Barack Obama and former President George W. Bush. Greg Mankiw, one such advisor, recently asserted: "In particular, the overall level of prices a decade hence should be about 30 percent higher than the price level today…[and] the stance of monetary policy sufficiently accommodative to achieve that degree of inflation over the coming decade."

 

Asset markets have ‘thrived’ under such a loose approach to monetary policy, with stocks, bonds, and commodities rising to record highs before collapsing spectacularly in late 2008. The sole protest could be found in the forex market, which is perhaps the most sensitive to changes in interest rates and inflation. In fact, the Euro’s steady divergence from the Dollar mirrors the contrasting approaches to monetary policy practiced by the Fed and the ECB, as well as the apparent indifference of the Bush administration towards fiscal responsibility. The Euro "soared against the greenback as the U.S. Federal Reserve made its historic mistake of flooding the world with dollars earlier this decade…[and] has climbed sharply again since Mr. Bernanke cut rates virtually to zero last month and signaled his new policy would be "quantitative easing" — i.e., printing as much money as it takes to revive the U.S. economy."

 

The Fed’s "Liquidity Program"

The Fed’s response to the credit crisis has been to flood the markets with "liquidity," through a combination of direct and indirect methods. The Fed began by attempting to stimulate lending indirectly by steadily lowering the interest rates that it charges member banks on overnight loans, not stopping until its benchmark Federal Funds Rate hovered slightly above 0.0%. As commercial banks failed to take the hint and continued to hoard cash, the Fed felt compelled to insert itself more directly into the markets, initially "announcing a program to buy $100 billion in the direct obligations of housing related government sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac and the Federal Home Loan banks — and $500 billion in mortgage-based securities backed by Fannie Mae, Freddie Mac and Ginnie Mae." This was quickly followed by repurchase programs, lending facilities, investments in money market funds, and option agreements, all of which were designed to supplement its "traditional open market operations and securities lending to primary dealers." The Fed’s efforts also worked to ease the liquidity shortage in credit markets abroad by entering into swap agreements with several foreign Central Banks suffering from acute Dollar shortages.

The end result was that "In just a few short months, the central bank has effectively become a substitute for banks and other lenders, especially in the commercial paper market and others that remain frozen to certain economic transactions. The Fed also stands ready to buy mortgage-related bonds, longer-term Treasury bonds, corporate debt and even consumer loans." The only problem is that the Fed’s financial resources aren’t adequate to support such activity, necessitating steep leverage. In fact, "the flagship branch of the 12-bank system, the Federal Reserve Bank of New York, shows assets of $1.3 trillion and capital of just $12.2 billion. Its leverage ratio, a mere 0.9%, is less than one-third of that prescribed for banks in the private sector." Only the brave are willing to ponder what would happen if any of these "investments" go sour.

Market Response

As previously stated, securities markets have reacted positively to the Fed’s policy prescription, since some of the liquidity will no doubt be used for asset speculation. Few economists share this sense of buoyancy, however: "The 2008 shock is so big that it cannot be shrugged off by households, like the 2001 downturn. With their wealth depleted, households will save: as a precaution in hard times, to make up for losses and try to regain their desired wealth path." This increase in savings will not only negatively impact GDP, but could ignite a self-fulfilling deflationary spiral. The Fed is terrified of this possibility, because deflation and a lack of confidence in the Dollar would quickly reinforce each other, causing "the flow of money to speed up as individuals become desperate to exchange cash for real goods as fast as possible, producing hyperinflation."

The Role of the US Treasury

The US Treasury Department, often acting on behalf of the US Federal Government, is also playing an increasingly prominent role in the policy response to the credit crisis. The previous six months have witnessed the poorly-managed $700 Billion TARP program, direct bailouts for failing companies in the automotive and banking sectors, as well as the far-reaching Obama economic stimulus plan, currently pegged at $825 Billion. Setting the substance of these programs aside, let’s instead focus on the fiscal impact. The federal government is now projecting a 2009 budget deficit of $1.2 Trillion, shattering the 2008 record of $455 Billion. The result is a (conservativative) estimate by the Congressional Budget Office that US government borrowings will increase by $3 Trillion over the next decade, which is not surprising given that the bailout could end up costing over $4 Trillion.

Unfortunately, "with the experience of the last eight years, the international financial community does not have too much faith in the ability of the United States government to act with appropriate discipline," and may not be easily convinced to absorb this increase in debt. While still considered a low possibility by most analysts, speculation is in fact mounting that the US will default on part of its debt. In addition, Timothy Geithner, recently appointed Secretary of the Treasury, crassly provoked China- previously the most reliable purchaser of US Treasury securities- by calling attention to its dubious currency policy. In short, it is becoming ever-more likely that the the Treasury Department will be forced to turn to the Fed, which in turn will be forced to "monetize" the debt by literally printing the required currency necessary to make up the shortfall. This will spur inflation, and "increases the likelihood that foreigners will not only stop buying Treasuries, but that they will sell the ones they have, and will dump US dollar holdings out of a concern of dollar devaluation by the part of the Federal Reserve." One editorialist offered a pithy summary of this dilemma: "If the Fed is going to create boatloads of depreciating, non-yielding dollar bills, who will absorb them?"

The World’s Reserve Currency?

The scariest prospect of all is that the Dollar will no longer function as the world’s reserve currency. In recent years, the Euro has steadily increased its share of Central Banks’ foreign exchange reserves, although it is still dwarfed by the Dollar. Since 2003, China has cut the portion of Dollars from 70% of its total forex reserves to 45%. In addition, several Middle East countries recently made headlines by announcing plans to abandon their respective currency pegs to the Dollar, because such was becoming increasingly costly, especially from the standpoint of opportunity cost. In other words, the Fed’s interest rate reductions have turned investing in short-term US securities into a losing proposition. The forex markets encapsulated this sentiment: "A day after the Federal Reserve adopted a near zero-interest rate policy to stimulate the economy, the Euro jumped as much as 4 cents against the Dollar, the largest single-day move since the euro’s birth in 1999." Even ignoring yield, investors realize that they are being burned on the risk end of the equation as well, given both the dubious nature of the assets newly guaranteed by the US government, as well as the fact that a bubble appears to be forming in the market for government bonds. Ironically, if the Fed is successful in stimulating investor risk appetite, it could prompt a rapid flight away from low-yielding Treasuries. "Any exodus now could spark selling across the board. Foreign debt holders would likely repatriate their funds immediately to reduce the risk of being last to convert."

Conclusions

In conclusion, we must accept that in the words of one commentator, "Washington’s policymakers have little choice as they aim to prevent America’s economy tipping into depression. But they need to be aware of the risks to the dollar. Zero interest rates, a contracting economy, a still large current account deficit and suspicious foreign investors are a potent combination that could lead to a rout of the currency." Ultimately, the Fed and the US Treasury must bear in mind that their policies hinge on a crucial assumption: that there is only a limited link between money supply growth and inflation. If this turns out to be false, any US economic recovery would certainly be followed by tremendous inflation, in which case the implications for the Dollar are clear.