Is the Fed Boxed In?

U.S. Dollar is "currency of last resort"

 

Central banks used to stick together, but those days are gone. What they have in common are weak banking systems that can't survive on their own.

 

If banks are addicted to stimulus, then are central banks the drug dealers? That's how it seems and neither side has an easy way out.

 

We like to think that the Fed and other central banks, because they have the power to create money, can do whatever they want.

 

In fact, the Fed is as captive to circumstances as anyone else is. They can generate cash out of thin air, but they can't override reality.

 

Today MarketWatch.com  ran an excellent opinion column by Satyajit  Das, a former banker and author of books including Extreme Money and Traders,  Guns & Money. I highly recommend both, by the way.

 

The Das story is called The Fed has boxed U.S. into a tough easy-money corner.  Here is how it begins.

 

Despite the Federal Reserve ending its purchases of Treasury bonds, U.S. monetary policy remains accommodative and will be for a long time  to come.

 

The downside is too great. Withdrawing fiscal stimulus would slow economic activity. Reduction in government services and higher taxes hits disposable incomes, especially when wage growth is stagnant. In turn, this leads to a sharp contraction in consumption. Slower growth, exacerbated by high fiscal multipliers, makes it difficult to correct budget deficits and control government debt levels.

 

Accordingly, the Fed's ability to reverse an expansionary fiscal policy is restricted, at best, corroborating economist Milton Friedman's sarcastic observation: “There is nothing so permanent as a temporary government program.“

 

The Fed is basically stuck.

 

I think Das has this right. The Fed ended QE3 with no definite plan for returning to “normal“ policy. (Not that their “normal“ is especially desirable, but at least it would  be familiar.)

 

Internal Sponsorship

 

Back when the Fed took  that last step toward ending QE3 on Oct. 29, I pointed out that they plan to continue rolling over and reinvesting interest  from their $4 trillion+ hoard of  Treasury and mortgage bonds.

 

That means their policy is still extremely accommodative by historic standards. Even if they raise interest rates a point or two next year, it will be “tighter“ only by a radically different, post-2008 definition of the word.

 

If you are a cash-addicted American banker, you can stop worrying. Your next fix may look different, but the Fed won't send you to rehab.

 

If the Federal Reserve is still pumping out cash despite the “tightening“ talk, what can we say about  other central banks? The European Central Bank and the Bank of Japan are in completely uncharted territory.

 

Look at what ECB head Mario Draghi said to a banking conference in Frankfurt last week, as reported by Reuters.

 

Painting a bleak picture of the state of the 18 countries in the euro bloc, Draghi stressed that “excessively low“ inflation had to be raised quickly.

 

In a blunt message, he said there was now no sign of improvement in the months ahead and the ECB would pump more money into the euro bloc if its current measures fell short.

 

“We will do what we must to raise inflation and inflation expectations as fast as possible,“ he told an audience of bankers in Frankfurt.

 

“If ... our policy is not effective enough to achieve this, or further risks to the inflation outlook materialize, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases,“ he said.

 

All right, then. Europe needs more inflation and Draghi says he will deliver it. The only question is how. Look for the ECB to start buying government bonds from the weaker euro-zone nations before year-end.

 

The Bank of Japan is already doing the same for its government. Last month, the BOJ stunned markets by increasing its quantitative easing program at an 80 trillion yen annual rate. That's about $60 billion per month.

 

The Fed's QE3 program was only $80 billion per month at its peak, and our economy is much larger than Japan's. The BOJ is also loading up its balance sheet with stock ETFs and real estate trusts.

 

Bank Governor Haruhiko Kuroda is taking his “lender of last resort” job much too seriously.

 

The yen and euro currencies understandably collapsed against the greenback in recent weeks. While either could have a corrective rally at any point, the dollar is quickly becoming the “currency of last resort.“

 

Our economy has its share of problems, but we are in better shape than the rest of the developed world. That's attracting capital into dollar-denominated assets like U.S. stocks.

 

In a weird way, I have to give the Federal Reserve credit for creativity. They created one bubble by pumping cash when our economy was in retreat. Now they are expanding the bubble even further by pumping slightly less cash.

 

Bubbles are the only constant in this equation. Eventually, someone with a needle will pop the bubble. Meanwhile, all we can do is enjoy it.

 

Source: Brad Hoppmann, Publisher, Uncommon Wisdom Daily

 

Comments

 

We are enjoying lower gasoline prices and could look forward to increasing oil and natural gas production and exports.  We are certainly not through this bad economy. It could last for decades.  Stagnant household incomes, more immigrants should result in more caution and lower demand. Our economy is actually shrinking.  We will benefit from a little deflation.

 

Norb Leahy, Dunwoody GA Tea Party Leader