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IPFS News Link • Federal Reserve

The Horrible Conundrum Facing The Fed

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We are also absolutely dependent on foreign energy sources and despite 30 years of political promises to resolve that problem we have refused to take the steps necessary to do so, including funding massive nuclear energy development and drilling for all of our currently-known resources as a bridge while those nuclear plants are brought online.  There is and has been zero political or public will behind accepting that resolving these problems does not lie in "pie in the sky" battery, solar and wind technologies, but rather through aquaculture-produced bioldiesel, massive nuclear power development and full exploitation of our existing fossil-fuel stores, all of which will cause energy costs to rise and exact what amounts to a tax on the American people.  In short we demand not only cheap TVs from China and cheap blue jeans from Vietnam but cheap gasoline from Saudi Arabia, and combined this makes addressing trade imbalance politically impossible.

Depreciating our currency makes internationally-represented firms such as Caterpillar happy, but this is a short-term phenomena, as competing producers in China can (and will!) over time cannibalize their sales into that market since their labor costs are so low.

We simply cannot afford to allow a self-reinforcing cycle to become established with dollar-funded carry trades.  There is a line beyond which the depreciation in the dollar causes such a trade to become self-reinforcing and extraordinarily destructive.  Exactly where that line happens to be is difficult to determine but that a profit/reinvestment cycle "kneepoint" exists is axiomatic.

Should we reach that point the dollar will come under attack in the FX markets to a degree that is literally impossible to stem.  FX markets move a couple of trillion dollars a day - intervention in those markets is both insanely expensive and futile over any material amount of time.

This is what those who are sounding the alarm over a potential currency collapse see in the future - and the risk they are speak of is in fact very real.

The only real means of defense against such a self-reinforcing cycle is to limit the number of dollars in circulation.  This means raising interest rates - either formally or effectively - through withdrawal of liquidity - forcing an unwind of these trades and raising the uncertainty level high enough that traders will not risk ruin - in other words, we must transform a near-sure-thing to a likely-bad outcome.

This is the flaw in Benranke's central thesis - that The Fed can continually respond to challenges in the economy by making money "cheaper" with each iteration.  History shows that indeed this is exactly what Bernanke and his predecessors have done, both formally in The Fed Funds rate and informally through intentional and willful loosening of the constraints on leverage and lending.

Yet this is a road that leads, ultimately, directly to Hell's Gate and somewhere along the line is a one-way trap door.

There is a limit in the economy on debt service at a given level of GDP.  The available "slack" between the current interest rates being charged and the maximum sustainable interest rate before default becomes inevitable is the "safety margin" that allows monetary policy to work.

By intentionally eroding that margin over time The Fed has now backed itself into a corner; it reached the "zero rate" boundary and yet wanted even more easing, so it began monetizing debt.

This is as clear of a declaration you will ever see that the economy will not support higher interest cost even with the formal Fed Funds rate at zero.

1 Comments in Response to

Comment by Anonymous
Entered on:

" The only real means of defense against such a self-reinforcing cycle is to limit the number of dollars in circulation."

The author states that there is only one means to do this - by raising interest rates.

There are TWO other means:

1) decrease government spending

2) increase income taxes.

The 1986 Grace Commission Report comissioned by Ronald Reagan demonstrated that income taxes do not go to fund government operations but are delivered to the Fed to retire old bonds.

So the article is wrong in this respect.