by Charles Kadlec
Monetary policy in the U.S. has tightened, inadvertently, but with potentially dire consequences for the economy, employment and the stock market. The source of tight money is a failure of the Fed to act in the face of a surge in the demand for dollars as individuals and corporations shift money balances out of the euro and into the dollar.
This episode is but the latest example of the cost of a monetary system that relies on the “best judgments” of a dozen voting members of the Federal Open Market Committee (FOMC) to set monetary policy. Without concrete rules and procedures that would permit monetary policy to adjust to the inevitable fluctuations in the demand for dollars as they occur, those in charge must wait for evidence in the real economy of either too much for too little money before they can arrive at a judgment as to what action to take next. By then, the Fed is relegated to damage control from its own inaction. The consequence is a more cyclical economy prone to financial crises.
The preponderance of evidence now points to a sudden and harsh reversal of inflationary pressures evident just a year ago, whipsawing commodity producers and adding monetary uncertainty to the existing impediments to economic growth in the U.S. and around the world.
Last June, the Fed’s second round of “quantitative easing” (QE2) was coming to an end. Over the prior eight months, the Fed had purchased $600 billion in assets, increasing the monetary base or supply of money by 33% above its year earlier level.
Such an increase in the supply of dollars in the face of steady demand led to a fall in the value of the dollar. Over those same twelve months, commodity prices as measured by the CRB spot commodities index were up 34%. Metals prices were up 37%, oil up 28% and foodstuffs up an incredible 45%.
But, when QE2 stopped, the Fed virtually stopped growing the monetary base. As a consequence, the year-over-year increases began to fall, hitting 29% at the end of December. By March, the 12-month change had dropped to 16%. By the end of May, the monetary base was virtually unchanged from its June 2011 level.
A zero increase in the supply of money may have been fine had not the European financial crisis intensified over the same period. As confidence in the sovereign debt of spread from Greece to Spain, Portugal and Italy fell, so did trust in the stability of banks stuffed with government bonds and the stability of the euro itself. The latest concerns over Greece and now Spanish banks has intensified the flight to the dollar.
If you hold the quantity of a good constant in the face of rising demand, the price of that good goes up. The same is true for the value of a currency. In the past year, the value of the dollar has gone up – 16% against the euro. The year/year change in the CRB spot commodity index is now minus 14%. The dollar price of metals and foodstuffs have fallen 17% and oil prices have dropped 15% to under $85 a barrel.
Apologists for the Fed will blame the decline in prices on a weak economy. But, that is exactly backwards. A swing from a 34% increase in prices to a 14% decline in prices is the epitome of price instability. That kind of instability increases uncertainty, and therefore makes it a lot harder to do business. When monetary instability makes it harder to do business, no surprise, the economy slows and job creation comes dangerously close to a halt.
The root problem is the Fed has no operating procedure to enable a timely response to rapidly changing demand for dollars. Instead, a dozen men and women on the FOMC meet every six weeks, review a hodgepodge of data on inflation and economic output, almost all of which is at least a month old and subject to revision, and then use their best judgment to set monetary policy. Such an approach provides no reliable answer to the fundamental operational question the Committee is charged with answering: Should the Fed expand, contract, or leave unchanged the monetary base through the sale and purchase of securities?
The consequence is an earnest debate among the members of the FOMC as each attempts to divine what to do next. Last week, for example, Fed Chairman Ben Bernanke necessarily was guarded in his testimony before Congress’s Joint Economic Committee. Speaking in double negatives about next week’s FOMC meeting he said: “At this point, I really can’t say anything is off the table.”
Really? Everything is on the table from interest rate hikes to another round of quantitative easing?
If the Fed were to announce another bout of “quantitative easing” as a response to economic weakness, it has no assurance that it would not undermine confidence in the future value of the dollar. If that were the case, dollar holders could begin to dump dollars as well as euros in favor of gold, precious metals and other foreign currencies. Such a drop in the demand for dollars would, in fact, be inflationary.
On the other hand, failure to act could lead to yet another financial crisis, as the downward pressure on prices reduces cash flow to businesses large and small, dims the prospects for corporate profits, and forces banks to pull back on loans to all but the most credit worthy borrowers. Faced with increased monetary uncertainty, individuals would hoard cash and insured bank deposits, further increasing the demand for money. The financial system would thus amplify deflationary pressures, leading to increased unemployment and triggering another recession.
Such a quandary is the result of a trial and error monetary system that ostensibly manages the economy, hopes to avoid financial crises, and strives to devalue the dollar no more than 20% over the next 10 years.
What is needed is a clear set of operating procedures that will empower the Fed to adjust the quantity of money to shifts in the demand for money in real time. By matching the supply of dollars to the demand for dollars, the Fed can restore price stability. Because price stability that can be trusted makes it easier to do business, implementing such a procedure is the only way for the Fed to meet its other legal obligation of encouraging full employment.
To achieve such a price rule, the Fed should consider announcing that it will arrest any further decline in a specified basket of spot commodity prices. Once the year-over-year change in such an index returns to zero, the Fed would then commit itself to expanding or contracting the monetary base in order to keep the year/year change of the commodity index to within a band of plus or minus 10%.
The stability provided by such a “price rule” would provide an important step toward restoring the ultimate guarantee of the quality of the dollar – once again making the dollar as good as gold. With the dollar’s purchasing power stabilized, restoring a dollar convertible into a fixed weight of gold would formalize and operationalize a robust, Constitutionally based price rule for U.S. monetary policy. The result would be a new era of price stability, economic growth, high paying jobs and rising standards of living associated with the gold standard throughout history.