classical economics
for analysis,  forecasting
and policy design

Cleaning House: Fed & Tr
At Treasury and the Federal Reserve

By Wayne Jett
© June 16, 2008
    No need for a redux of President Gerald Ford’s 1975 WIN button campaign to defeat inflation. Inflation can be eliminated promptly by reforming U. S. monetary policy. Absent policy reform, however, the Federal Reserve will continue causing inflation, higher unemployment and declining standards of living for Americans and others globally.
    Presently the Federal Reserve is allowed to cause inflation, and does, by manipulating the dollar’s value as a weapon of trade war. In just five years, the Fed has cut the dollar’s value by two-thirds relative to gold, and presently the dollar is down 60% from 2003. That hard fact means prices, wages and living standards must adjust to the dollar’s diminished purchasing power. The Fed tries to keep wages and price from rising, which maximizes the fall in living standards.
Abysmally Bad Monetary Policy
    What the Federal Reserve does when it claims to “fight inflation” is every bit as ineffective and nonsensical as the WIN buttons of the Seventies. The Fed claims raising the interest rate on loans of overnight bank reserves (the “funds rate”) tightens credit, puts workers out of jobs, and thereby prevents them from demanding higher wages. Preventing wage hikes, the Fed says, retards price increases in two ways. First, high prices are not needed by producers to pay higher wages and, second, consumers can’t afford to pay higher prices without wage increases.
    This is abysmally bad economic policy. It is incapable of achieving anything better than stagnant wages, stagnant economic growth and declining living standards as the dollar’s value wastes. It does no more than the WIN button to increase the dollar’s value.
    In fact, the Fed’s current practice of manipulating the so-called funds rate “target” is worse policy than the WIN button. The funds rate target serves as an artificial benchmark for bank loan rates. If the Fed’s target is higher than the market would set the overnight rate, small business and other bank customers are charged unreasonably high rates. If the Fed’s target rate is lower than the market would set, it encourages lending and borrowing that the market would not. In either case, manipulation of domestic interest rates actually harms the economy.
    Whether these interest rate manipulations weaken or strengthen the dollar depends on the Fed’s “other hand,” meaning what the Fed does to inject additional monetary base or to drain dollars from it. The Federal Reserve does this by buying Treasury securities (injecting dollars) or selling them (draining dollars) through the open market desk of the New York Federal Reserve Bank. These liquidity flows are not determined or controlled by the funds rate target. The funds rate target is not the liquidity valve it is commonly stated to be in financial and business media.
Ingredients of Credit Crisis
    From June, 2004, through 2006, the Federal Reserve injected new liquidity even while raising the funds rate target to 5.25% to slow economic growth and increase unemployment. This rate was so far above market that the yield curve was sharply inverted for nearly two years. Small business refused the artificially high cost of bank credit, stopped expanding and hiring, and began shrinking and firing. Meanwhile, investment banks, hedge funds and other financial institutions willing to accept high rates, high leverage and high risk sucked up new liquidity injected by the Fed.
    The slowed economy combined with new liquidity injections to produce the sharply weaker dollar, with gold rising to $735/oz in May, 2006. As 2007 began, the Fed stopped the music by ending its liquidity injections – without broadcasting the news, of course. The Fed purposely keeps its liquidity operations close-to-the-vest by withholding release to the public of its open market operations for five months after month-end.
    Recent commentary published by expertly details the miseries of inflation and includes an “ugly chart” depicting the banking index drop from 120 to 70 due to the inverted yield curve created by the Federal Reserve. Here is the chart (courtesy of

Author John Mauldin predicts the chart “will get uglier, but it will collapse without a positively sloped yield curve.” Note the banking index rose despite an inverted yield curve from 95 in October, 2005, to 120 in the first quarter of 2007, a gain of 26%, but peaked when the Fed combined the inverted yield curve with no new liquidity at the outset of 2007.
Mopping Up the Mess
    By August, 2007, the international credit markets verged on seizure and collapse largely as a result of the Fed’s monetary machinations. Easy liquidity and declining dollar during 2004-2006 encouraged leveraged buying of hard assets, including housing. Poor quality loans packaged in complex derivative securities began defaulting as the Fed’s actions to increase unemployment bit hard at sub-prime mortgage borrowers. To relieve the collapse of confidence in credit quality, the Fed began large injections of new, though temporary, liquidity and, in September, reversed field on the funds rate by lowering the target.
    The Federal Reserve auctioned liquidity to closer approximate market rates for credit, exchanged Treasury securities for lower quality assets held by banks, and injected new capital into Morgan Chase Bank to prevent its collapse through exposure to Bear Stearns’ investment banking risks.
    All of this involved the Federal Reserve mopping up messes created by its own ill-advised policy. Once again, however, the media portrayed these events as wise Fed rescuing wayward private economy.
Death of Credibility
    In this tender and vulnerable environment, Treasury secretary Henry Paulson, recently of Wall Street’s investment bank, Goldman Sachs, proposed granting the Federal Reserve overall authority to regulate the financial markets. Paulson suggested the Fed be responsible for investigating and disclosing conditions relevant to financial markets, and should be empowered to “take corrective actions when necessary to ensure overall financial market stability.”
    While considering advisability of these proposals, weigh the implications of public statements made repeatedly by Secretary Paulson since his July, 2006, appointment that U. S. policy favors a “strong dollar.” In the scale with strong dollar policy, put the Fed’s oft-stated vigilant devotion to fighting inflation, together with frequent public commentary noting the Fed’s deliberate devaluation of the dollar to remedy foreign trade deficits.
    On the other side of the scale, balance the fact that the dollar is presently worth 60% less than it was worth five years ago relative to gold and in the eyes of the world’s producers of crude oil and other goods and services. In that light, how much credence should investors and markets give to Treasury’s proposals and to the Federal Reserve’s often obtuse pronouncements?
    The U. S. Treasury and the Federal Reserve have destroyed their credibility in financial circles of the world. They retain center stage in international economic matters only because the U. S. economy is so significant, which is not at all to their credit.
Dump Mercantilist Orthodoxy
    Policy at Treasury and the Fed is dominated by Wall Street institutions and related investment firms. Neither Treasury nor the Fed will change policy unless forced to do so by the President or by Congress.
    Inflation can be eliminated almost overnight by stabilizing the dollar’s value relative to the price of gold. Managing liquidity while allowing the markets to set the gold price can do all that is necessary. That achieved, every producer in the world will view the dollar as a rock of stability. Those insisting otherwise are charlatans of the chaotic status quo, who have been entrusted too long with guidance of U. S. economic policy. Already they have done too much damage, and must go now. ~