classical economics
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and policy design

Good Turn by Dollar
By Wayne Jett
© August 15, 2008

    Eureka! Something positive to say about the Federal Reserve’s actions, if not its policy! The dollar price of gold touched $775 per ounce August 15, about 23% lower than its peak during March and 20% below its peak only last month. This is real progress towards restoring the dollar to a respectable value, although a farther distance remains before the dollar returns to non-inflationary range. Getting there will require proceeding to a gold price at or below $500 per ounce.
  The declining price of gold results partly from improving prospects for real economic growth due to the declining price of crude oil. However, the gold price signals the Federal Reserve is doing something right in manipulating interest rates and liquidity. The funds rate at 2% is much closer to a market rate than at any time since 2004, though it is still above market by about 1%. Where the Fed erred most was in its actions injecting liquidity while raising the funds rate during 2004-2006.
Draining Liquidity – Big Time!
    On August 14, the Fed released data on its open market operations during March (four months delayed to the public) showing $108.9 billion drained from private liquidity! Combined with open market operations from December through March, the Fed has drained $168.125 billion through net sales and redemptions of Treasury securities. For the first time since 2004, it may be said that the Federal Reserve acted responsibly regarding its duty to maintain the dollar’s value. At least during March that was the case, which coincidentally perhaps was the same month the Fed financed the takeover of Bear Stearns by J. P. Morgan Chase & Co.
    Unfortunately, the Federal Reserve keeps the public in the dark four and a half months before releasing its open market data. So we must wait another month to know what was done to liquidity during April. This delayed reporting by the Federal Reserve disserves the public interest. The longer such data are withheld from the public, the greater is the likelihood participants in the financial markets gain access to it with opportunity to exploit their advantage through investment transactions. Surely Fed governors understand that transparency and fairness in U. S. financial markets must begin with the Fed’s own actions.
    The Federal Reserve’s historically high draining of liquidity raises the distinct possibility that the recent decline in price of crude oil may be driven, at least in significant part, by Fed liquidity management. Again, without more recent data, this cannot be said with certainty. Futures trading continued pushing the price of crude oil higher in March, despite the Fed’s drainage, and peaked only at the end of June under pressure of potentially effective regulatory oversight. Again, this hints at how consequential Fed actions can be for the good, as they have been for bad dollar performance and bad economic growth.
Liquidity Detached from Funds Rate
    The March open market transaction data ought to dispose of the contention by some economists that the Federal Reserve took a “massive turn toward loose money” last September when reductions in the funds rate began, ultimately moving this benchmark for bank credit rates from 5.25% to 2%. Indeed, can economists maintain any longer that liquidity is “driven” by the funds rate – i.e., that the Fed open market desk must blow new money into the private economy in order to drive the funds rate lower? The Fed actually drained $168 billion as the funds rate was cut by more than half from 5.25% to 2.5%! The funds rate is not the valve of liquidity it has pretended to be!
    Open acknowledgement of this demonstrated fact by the Federal Reserve would have tremendously positive implications for working Americans and dollar users globally. The funds rate need not be raised – i.e., jobs need not be destroyed or economic growth stifled – in order to strengthen the dollar! This entirely fallacious Keynesian bugaboo has tormented the world far too long already. Monetary inflation is not fought by putting workers out of jobs or by reducing production with high interest rates. Those actions make inflation worse and require workers to absorb it in lower standards of living. Inflation is made or eliminated by Federal Reserve actions to meter liquidity provided to the economy.
    The path to sound U. S. monetary policy is clear. Float the funds rate and allow markets to set rates for bank credit. This will eliminate such horrendous experiences as the misallocation of liquidity that produced the housing, sub-prime mortgage and credit quality crises. Then deliberately target a non-inflationary, stable value for the dollar (near $500 per ounce gold) and America will finally provide quality global monetary leadership that has been lacking so long. ~