classical economics
for analysis,  forecasting
and policy design

Placing Blame

By Wayne Jett
© August 13, 2008

    Of many economists who offer explanations or forecasts of events, Brian S. Wesbury deserves more respect than most. He supports classical tax policy (low marginal tax rates) and opposes currency devaluation, but unfortunately uses too much Keynesian analysis in deciding how to achieve a sound currency.
    On August 11, he blamed “a massive shift in Federal Reserve policy toward loose money” in September, 2007, for the weak dollar, CPI up 5% and PPI up 9% year-over-year, record-high energy prices, high commodity prices and sharply lower economic growth in the U. S. and globally. Wesbury is right in wanting a stronger, stable dollar. But his analytical errors produce a remedial prescription that would do more harm than good.
Liquidity Drives Funds Rate?
Not in this Life!
    He begins well by noting that the price of gold has more than doubled since 2004, but fits the facts to his thesis by crediting much of the gold price rise to the past 12 months, during which the Federal Reserve began last September to reduce the funds rate from 5.25% to 2%. This is his springboard for more fundamental error, where he states: “Between September 2007 and April 2008, the Fed added enough dollar liquidity to drive the federal funds rate down from 5.25% to 2.0%.”
    The price of gold rose to $735 per ounce in May, 2006, when the Federal Reserve remained in the midst of its second year of funds rate hikes. Gold was up from $380 to $400 per ounce while the funds rate was only 1% in 2003 and early 2004. On August 12, gold closed at about $810 after touching below $803. This is down from $975 in March and a peak of $1,035 per ounce in March, and is closing on $750 where the gold price was at the end of last September, which is when Wesbury says the “massive shift … toward loose money” began.
    Spot-priced agricultural and industrial commodities traced similar peak-and-decline patterns during the past year, subject to specific supply-demand issues. Neither gold, the only monetary metal, nor other commodities support the premise that a massive shift to loose money occurred less than one year ago. The Federal Reserve’s injections of liquidity came during 2004-2006 when the funds rate was at or near 5.25%.
    This leaves Wesbury’s assertion that the Fed injected massive new liquidity since last September “to drive the federal funds rate down from 5.25% to 2.0%” wanting evidentiary support. Fed open market operations did not inject funds in 2007, but were essentially neutral all year until massive draining in December, which left 2007 a net reduction of liquidity by $48.355 billion. In January, an additional $43.5 billion was drained, and then $32.5 billion was injected in February. To date, data released by the Federal Reserve do not evidence massive injections of new liquidity since September by purchasing of Treasury securities; quite the reverse, although data for open market operations during March through July are undisclosed.
Facts of Fed Life
    This being the case, what has the Federal Reserve done to “drive … down” the funds rate from 5.25% to 2% since September? Some of its Treasury securities have been exchanged for other assets owned by private firms on an interim basis to improve private liquidity, but that merely changes private asset classes. Loans have been made through the discount window collateralized by privately-owned assets. Such loans are new funds created by the Federal Reserve, but they remove private assets from the economy, and so are in some ways akin to bank loans as much as liquidity injections. Surely the Federal Reserve is not using these ad hoc transactions as its instrument for hitting a funds rate “target,” or for exhibiting a massive move to loose money policy. In clearer perspective, the Fed is attempting to salve damage done by severe misallocation of liquidity that resulted from its ill-advised combination of inverted yield curve and liquidity injections during 2005 and 2006.
    How did the Federal Reserve drive down the funds rate from 5.25% to 2%? As detailed in previous reports of The Supply Side Guide, the Fed simply announced its new funds rate “target” and the big banks promptly adopted that rate for overnight reserve loans. The reduced overnight loan rate returned the yield curve almost to normal, thus enabling small business to obtain bank credit at nearly reasonable market rates for the first time in two years. This improved economic environment may permit small business to begin creating jobs again instead of eliminating them, strengthening the dollar in the process.
Rising Oil Drove Dollar Down
    Considering that the Federal Reserve has not made massive injections of new dollar liquidity since last September, and so could not have driven down the dollar’s value by that means, what of Wesbury’s contention that these two related factors caused the price of crude oil to double within the same period? Simply put, the more-than-doubled price of crude oil was not caused by the declining dollar. Crude rose for different reasons, also explained previously in The Supply Side Guide. The soaring price of crude actually contributed as a cause of the dollar’s decline, not the other way around.
    Prices of crude oil were driven up by manipulative trading practices in the “dark” futures trading markets left unmonitored by the Commodities Futures Trading Commission. Sharply rising fuel prices slowed economic growth, shredding growth prospects of airlines, trucking and other transports especially, and threatening collapse of the global economy. Finally, the aggravated and suspicious American public communicated its anger to Congress, which held hearings during May and June. Testimony and evidence presented were found compelling on a bipartisan basis. As Congress took its Independence Day break, prospects were good that legislation designed to stop the crude oil price manipulation could pass both houses before the August recess. That is when the price of crude oil peaked and turned downward.
Regulatory Threat Curbed Oil
    As the price of crude oil declined, prospects for economic growth and demand for dollars improved. Hedge funds and investment banks went wall-to-wall with lobbyists in Congress. House Speaker Nancy Pelosi turned out the House lights for the August recess, denying even demands from her fellow Democrats to allow votes on legislation that would address painful gasoline prices. Senate Majority Leader Harry Reid (D-NV) accomplished an equivalent result in the other chamber. Leaders of both parties ignored price manipulation as the chief cause of high prices for crude oil, with Republican leaders insisting on more domestic drilling and Democratic leaders promoting nothing but alternative energy sources and conservation.
    Republicans remain in the adjourned House, keeping public attention on their demand for votes on proposals for more oil drilling on public lands, or for compromise on the energy problem. Pelosi has signaled she will permit a vote on something, although she doesn’t want to reconvene until after Labor Day. But a funny thing happened during July and the ensuing political posturing. The price of crude oil began declining as investors in the crude oil futures game began edging towards the door, not wishing to be trampled in a crush resulting from full-fledged price collapse. After all, experts in energy and futures trading told Congress fundamental conditions justified a crude oil price no higher than $45 per barrel, and predicted that price (or lower) could be achieved within days if Congress prohibited the trading “speculation.” Who knew?
    Prices of crude oil have declined even after the August recess began. So have prices for other commodities affected by similar speculative investment. And, as those prices fell, prospects for economic growth in the U. S. and elsewhere improved.
Rescuing the Dollar
    An improving economy certainly is beneficial to the dollar’s value, just as the weak economy produced by the Fed’s inverted yield curve contributed greatly to the dollar hitting its lowest value in history in early 2008. The historic low of $1,035 per ounce of gold precipitated from Federal Reserve malfeasance in waiting too long to lower the funds rate – not from cutting the rate too much too soon as Wesbury contends. If he were right, the dollar would be falling further - not strengthening now.
    Why does it matter? The point is crucial, because Wesbury’s erroneous analysis leads inevitably to a conclusion that the Federal Reserve ought to raise the funds rate target significantly as soon as possible, meaning as soon as the November elections are past. This would be harmful to U. S. and global economies in every way, weakening economic growth and the dollar by destroying production and jobs.
    Far too many U. S. economists indulge the fallacy that the Federal Reserve hits the funds rate target by metering liquidity injected into or drained from the economy.  This indulgence enables the Fed to manipulate interest rates and liquidity in patterns that intentionally change the dollar’s value drastically, robbing all who accept the currency as stored reward for their labors. One who argues for a higher funds rate as the path to maintaining or restoring dollar value abets the robbery, if not intentionally, then at best out of ignorance.
    Curb fraudulent manipulation of crude oil futures. Float the funds rate and stabilize the dollar’s value relative to gold. These actions would bring U. S. economic policy two-thirds of the way out of the financial ditch it currently occupies.~