The “Walk” on the Dollar
By Wayne Jett
© October 30, 2007
It’s all about the Federal Reserve. The dollar, the economy, the equity markets, the bond markets, the crude oil and commodities markets – all are victims of the Fed’s mismanagement of U. S. monetary policy. Every market is volatile, as investors show the stress of enduring one crisis after another, each one with hidden links to the Fed’s practices.
The Fed’s economic theories are no longer relevant in debating its actions, because theory is really not determinative of what the Fed does in managing the dollar. After years of no discernible acknowledgment by the Fed of a multiplicity of arguments showing the absurdity of raising interest rates to put workers out of jobs as the primary means of retarding monetary inflation in capitalist economies, it is clear the Fed is impervious to rational argument or criticism of its monetary theory. Regardless of all else, the Fed refuses to consider any approach to managing the dollar other than manipulating domestic interest rates. Better to ignore the rhetorical fog thrown up to disguise its motives and to concentrate on why the Fed insists the funds rate must be its policy instrument.
Flaws in U. S. Monetary Policy
Before leaving behind theoretical objections to Fed practices, a list summarizing them will furnish context for the current international monetary dilemma.
Fighting Inflation with Unemployment
(1) The Fed professes to use the Phillips Curve within a Keynesian model to guide its monetary management operations. The Phillips Curve reflects data indicating that wages do not rise as fast when unemployment is higher. Thus, treating inflation as if it is a rise in prices rather than a fall in value of the dollar, the Fed asserts that raising the funds rate (the interest rate charged for overnight loan of reserves among member banks) will reduce aggregate demand for goods, which will reduce production, thereby reducing employment, reducing demand for higher wages and reducing rises in prices. This is fallacious for a number of reasons.
(2) Inflation is a monetary phenomenon characterized by decline in value of the currency unit. It occurs when the central bank issuing the currency creates a greater volume of new currency than is demanded by growth in goods and services in the economy. When the value of the currency unit changes, all assets, goods and services priced in that currency must be re-priced if their value or marketability is to be maintained. This re-pricing work is difficult, costly and retards economic growth, particularly when changes in currency value are kept secret from the public.
(3) The primary function of any central bank, including the Fed, ought to be achieving continuous stability in the value of its currency. Historically, this has been done by keeping the currency’s value stable relative to gold, meaning that the price of gold in the currency does not change. Since the Fed began manipulating domestic interest rates in 1971, instead of keeping the dollar’s value stable relative to gold, the price of gold in dollars has been very volatile. This signals that the dollar’s value has been volatile, and generally has fallen relative to gold by about 96% during those 36 years. Thus, manipulating domestic interest rates is an ineffective tool to achieve stable currency value.
Funds Rate Incapable of Stabilizing Dollar
(4) That the funds rate is useless in stabilizing the dollar’s value is provable mathematically. Try to write an equation to determine the dollar’s value and you will find it impossible to assign the funds rate a functional role that causes either directly or inversely proportional effects. As the funds rate is manipulated, other variables play in the markets causing the dollar’s value to change in a way that comprehends all of the changes – but is unpredictable based on the funds rate change alone.
The Fed Is At Fault
(5) The dollar’s instability is the Fed’s responsibility alone, and cannot be fairly blamed on fiscal budget deficit, current account deficit, excessive economic growth or the psychology of inflationary expectations. Each of these excuses has been used by Fed spokesmen to distract attention from the Fed’s own failure to balance creation of currency liquidity with needs of economic growth. During 1996-2001, for example, the Fed created severe deflation (a rise of about 50% in the dollar’s “spot” value) by draining liquidity while economic growth rose strongly. The deflated dollar precipitated sharply reduced prices, business operating losses, capital flight from all business sectors and eventual collapse of corporate share prices. By contrast, during 2004-2006, the Fed raised the funds rate, slowing economic growth and reducing demand for dollars, while continuing to inject significant additional liquidity. This combination of reduced demand for dollars and liquidity injections produced a sharply weaker dollar (a fall of about 50% after value equilibrium had been achieved in 2003).
Funds Rate Is Separate From Liquidity Management
(6) Glaringly different results during periods of essentially equivalent Fed funds rate actions (relative stability of the dollar during 1988-1995, severe dollar deflation in 1996-2001, and severe dollar inflation in 2004-2007) point to the same conclusion: the Fed is not managing dollar liquidity by means of funds rate “targeting.” That conclusion is confirmed by the Fed’s emergency injections of liquidity in August, 2007, which produced no lasting change to the funds rate. The Fed is setting the funds rate. Its member banks abide by the set rate because they gain important business advantages by doing so. The Fed separately injects or drains liquidity through its open market operations by buying or selling Treasury securities, or repossession contracts covering such securities.
Dollar Is Victim of High Funds Rate and Excess Liquidity
(7) In a television interview on October 26, vice president Cheney was asked whether he is concerned about the weak dollar. Predictably, he answered that U. S. policy supports a “strong” dollar, and that the markets should set the dollar’s value so that instability cannot accumulate in fixed exchange rates. This is standard policy stated by the U. S. Treasury. But it fails to acknowledge that (a) if U. S. policy favors a “strong” dollar, it is failing badly, and (b) markets determine the dollar’s value based on supply and demand, and supply of the dollar is entirely within the Fed’s control. If the Fed adds too many dollars to the economy, the value of each dollar falls. The dollar’s value falls even faster if the Fed reduces demand for dollars with a high funds rate while concurrently adding more liquidity. This is what the Fed has done during most of 2004-2007. In this context, a high funds rate is one that is above the normal yield curve, as is the case presently despite the September reduction of 50 bps. The current funds rate of 4.75% creates an inverted yield curve relative to all other terms from three months to 30 years. This throttle on economic growth in small and medium-sized business plus excessive liquidity injections by the Fed produces the sharply weaker dollar.
Mercantilist Objectives Govern Fed Actions
Extending the list of flaws in Fed theory further would simply add redundancy to the demonstration of irrationality in the Fed’s rhetoric. The bottom line is that the Fed is utterly unswerving in its commitment to manipulate domestic interest rates with the funds rate. This hard reality means two things: (1) commercial and investment bankers want and demand continued manipulation of domestic interest rates; and (2) attempting to debate Fed theory wastes intellectual energy because it will not influence Fed practices.
The funds rate announced regularly by the Fed is used by commercial bankers as a benchmark to set non-competitive interest rates charged to their customers. Without the Fed’s role, banks could not jointly set such a benchmark without violating federal anti-trust laws, subjecting themselves to suit for treble damages and criminal sanctions.
For investment banks and hedge funds, manipulation of domestic interest rates by the Fed according to patterns and plans that can be learned through insider communications provides significant advantages during the resulting cyclical moves in asset prices. As interest rates are raised, asset prices crest and eventually collapse, providing a buying opportunity for parties with plentiful capital. After purchased assets are in hand, such investors are prepared and eager for economic recovery. At this moment, the Fed customarily cuts interest rates sharply to retard further recessionary contraction, and asset prices begin their rise to another cyclical high. This is not a “business cycle” produced by the private economy, but is the response of markets to changes in economic conditions imposed by a central authority: the Federal Reserve.
Bankers do not mind what theory Fed governors use to explain their actions, so long as their actions are deemed suitable. Let Fed actions wander into unsuitable territory, though, and every theory cited as support will be swatted like a bothersome gnat. Only in such an extraordinary organizational context can the counterintuitive and unhelpful Keynesian economic theory survive at the Fed. Its purpose is to confuse and distract outside observers, rather than to guide Fed actions.
The Mercantilist Monetary Environment
The complex institution called the Federal Reserve has ushered America and the world to a time of chronic monetary instability centered upon the dollar. The dollar presently remains the primary international reserve currency (meaning the currency held by most central banks as financial reserves rather than gold). But the dollar’s once preeminent role in the world diminishes daily. Twenty years ago in October, 1987, investors engaged in a brief but determined “run” on the dollar, abandoning dollar-based assets in U. S. markets in favor of assets in Europe or Japan. Order was restored in U. S. markets through assurances of dollar stability, which were honored for nearly ten years. The more recent ten years, however, have featured a horribly debilitating over-valued dollar during 1996-2001 followed by an alarmingly weak dollar in 2005-2007. The dollar was weaker during 2006 than any year in history other than 1980, and 2007 is becoming the dollar’s worst year in history.
So far in 2007, U. S. financial markets have not suffered a “run” on the dollar, but August saw a determined “walk” from the dollar begin. Investors are walking away from dollar-denominated assets to whatever other assets seem more attractive presently. The walk has not degenerated into a run because the world lacks a defensible currency other than the dollar. Several other currencies (the euro, the Canadian dollar and the yen, for example) are stronger in the sense that they have not inflated as fast as the dollar. But no currency other than the dollar is dependably protected by national security forces over the long term. If the U. S. loses the advantages of monetary and economic leadership, how long will the U. S. be able to provide a defense umbrella over open market economies? The euro appears attractive presently, but its attraction will dim quickly if Islamist factions move to implement stated intentions to replace European governments with their own caliphates. The hesitancy of investors to run from dollar assets to the euro indicates this risk to the euro is becoming visible on the horizon. This is a thin reed of support for stability in U. S. financial markets, which explains much of the current volatility.
Surviving Fed Practices
Short of policy reform, the Fed must do better in moving the dollar’s value back towards equilibrium near $450/oz of gold rather than near $800/oz as is currently the case. On its current course, the Fed will cause a run on the dollar as investors seek shelter from the currency in gold, commodities such as crude oil, inflation-protected Treasuries and euro-denominated assets. To do better, the Fed should float the funds rate and manage liquidity towards a price target for gold near $450/oz, or at least cut the funds rate to a point near the normal yield curve (about 3%) while curbing liquidity injections until the dollar strengthens to that gold price.
Under current mercantilist influences, the Fed is likely to continue appeasing commercial bankers by keeping the funds rate too high, and to accommodate demands for excess liquidity to assuage leverage stresses in the LBO, CDO and prime brokerage communities. This portends an even weaker dollar and greater difficulties for investors seeking shelter while walking away from it. ~