Economy

The Fed's Potent Medicine


The Federal Reserve voted Nov. 4 to continue administering the strong medicine of cheap money to the feeble U.S. economy, even though that medicine is having undesirable side effects, including a speculative surge in the price of gold. Fed rate-setters voted unanimously to keep the federal funds rate at a rock-bottom range of zero to 0.25%. And they gave no sign that they're going to raise rates any time soon.

"Inflation will remain subdued for some time," the Fed said in its Nov. 4 statement, adding that weak conditions "are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The Fed's decision, while expected, was not easy. On the positive side, near-zero interest rates on overnight loans between banks are slowly helping revive the economy. On the negative side, cheap money is fueling speculation, driving gold prices to record highs of more than $1,000 an ounce and pushing the dollar lower against foreign currencies. If gold's rise and the dollar's fall begin to make the general public think that inflation is catching on, the Fed will be in a difficult position, because expectations of rising prices can become a self-fulfilling prophecy.

No Sign of Wavering For now, the Federal Open Market Committee seems to have decided that with the economy so weak, inflation remains a distant threat and speculation is an unfortunate but manageable side effect. The Fed is continuing to keep short-term rates at their lowest levels on record, hoping to encourage more borrowing for spending and investment so the recovery gains strength.

Fed watchers had wondered if the Fed, seeing signs of recovery, might soften its commitment to keeping rates low "for an extended period." But it didn't waver. The biggest change from the Sept. 23 statement was a small decrease in the amount of corporate debt the Fed intends to buy from the federally chartered mortgage-buying companies like Fannie Mae and Freddie Mac in order to support the housing market. That amount is shrinking to $175 billion from $200 billion.

The FOMC's firm support for the medicine of cheap money may come as a surprise considering several voters on the committee are known as inflation hawks. The explanation seems to be that even the hawks at the Fed were deeply shaken by the severity of the financial and economic collapse and don't think the economy is ready for higher rates.

"Guys who worked every weekend on this crisis know just how fragile the recovery is," says Ethan Harris, head of North America economics for Bank of America Merrill Lynch (BAC). While the hawks will eventually want rates higher, "The split between the superhawks and the doves for the short term is quite narrow," Harris says.

By contrast, doves on inflation are scarce in the commodity and currency markets. In pit trading on Nov. 4 before the Fed's decision was announced, gold rose nearly $7 an ounce to about $1,092, a record. In an interview on Bloomberg Television, investor Jim Rogers predicted it would reach at least $2,000 an ounce in the next decade. Rogers also saw trouble ahead for the dollar, which has fallen about 15% against a basket of major foreign currencies since early March.

A Lot of Slack in the System Speculation has also hit the oil market, where crude is trading for around $80 a barrel, a nearly 60% increase so far this year, despite adequate inventories. Some investors buy oil futures because they think they will go up if the dollar goes down.

In another concern for the Fed, some investors are borrowing dollars cheaply and then exchanging them for the currencies of countries like Australia and Norway, where interest rates are higher. Oddly enough, traders have sold dollars in response to signs of revival in the U.S. economy, apparently on the theory that a U.S. recovery is good for all countries, including the likes of Australia. A certain amount of decline in the dollar isn't bad because it increases the competitiveness of American goods in world markets. But a weakening greenback also tends to heat up inflation.

The main reason the Fed has ignored all these warning signs of inflation is that inflation rarely becomes a problem when there is a lot of slack in the system: i.e., many underused factories and unemployed workers. "Businesses are still cutting back on fixed investment and staffing, though at a slower pace," the Fed said in its statement.

The Fed can also take some reassurance from the bond market, which is sensitive to inflation because it erodes the value of fixed-income securities. Bond investors have been signaling that they aren't too worried about inflation, tolerating a yield of only around 3.5% on 10-year Treasury notes, vs. the 5% they demanded just over two years ago.

Financial markets took the Fed's announcement in stride. Shortly after the 2:15 p.m. ET announcement, the yield on the Treasury's 10-year note popped up to 3.54% from 3.5%, indicating a bit more worry in the market that the Fed would be soft on inflation. The Standard & Poor's 500-stock index held earlier gains to trade 1.1% higher, at 1,057.
Coy_190
Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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