by Country Thinker | March 1st, 2012
Thoughts on Economics
Last year I wrote that the Fed’s various quantitative easing programs had put our nation’s central bank between a rock and a hard place. George Melloan had an editorial Monday that echoed many of the same sentiments, as well as adding a few additional observations that suggest the Fed is becoming increasingly politicized.
The rock and a hard place is this: To create the new “money” in the economy (the “easing”), the Fed has been buying up large quantities of U.S. Treasuries. I picture it this way. Imagine the Fed has a closet full of money. When they want to increase the money supply, they pull money out of the closet, and trade it for Treasuries. This tends to make the interest rate on Treasuries go down, because there are more buyers in the market fighting for the Treasuries.
But when inflation begins to heat up, the Fed needs to “mop up” the excess liquidity. They do this by reversing the process, pulling the Treasuries out of the closet, trading them for dollars, and then putting the dollars back into the closet. This tends to make interest rates rise as the number of Treasury sellers goes up and the number of buyers goes down.
So, if the economy heats up, the Fed is going to have to start dumping its Treasury holdings to keep inflation down. That means that our debt service costs will rise, at a time when debt service is already projected to be the fastest growing category of federal spending. In other words, the Fed may have to choose between inflation and blowing a hole in the already dangerous deficit.
Melloan called the Fed “the handmaiden of the White House and Congress,” and there are two parts of that comment that relate to the rock-and-a-hard-place problem I laid out above.
First, the Fed has held interest rates at zero or near zero for years, and will do so for at least two more. This has kept interest rates on government debt low, but it has also artificially depressed earnings on a lot of safe investments such as CDs. Charles Schwab has been ranting about this problem for the last few years, as many of his conservative investors—particularly seniors who are trying to protect their retirement—are the ones feeling the pain of artificially low returns.
Because the effect of the Fed’s interest rate policies has been to lower the deficit on the backs of retirees. You can think of it as a stealth tax on grandparents.
Second, Melloan notes that the proposed Volcker Rule (a spawn of Dodd-Frank) has adopted the Basel II capital requirements, in which Treasuries are rated as zero risk. So banks are being incentivized to retain large holdings of Treasuries to lower their “risk exposure” instead of making business loans. As European banks found out with their Greek debt holdings, sovereign debt isn’t necessarily risk-free even if regulators rate it that way.
So all and all, the Fed is increasingly becoming a political servant, and its policies are tailored more and more for the benefit of the federal government. If this trend holds, you can expect high inflation before the Fed will clear its balance sheet if the Fed has to choose between inflation and higher debt service costs.
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Again, ESP at work. Just yesterday I made the comment to Jim, of Conservatives On Fire, that “the Fed has become politicized” and is frequently doing the WH’s bid.
Basically, the Fed’s double mission of stable prices and low unemployment are frequently at odds with each other, and at odds with the election prospects of its current masters.
John Galt recently posted..We Are Losing Our Freedom … And Our Wallets.
Too funny. I agree that the dual mandate is out of touch, and I think it dates back to the Phillips Curve era.
Country Thinker recently posted..The Fed Goes Political
Nothing is more American than a private central bank, which is controlled by a European central bank using it’s money to influence our government.
Trestin recently posted..Barack Obama
Wait until it’s controlled by a world central bank!
Country Thinker recently posted..The Fed Goes Political
I like your lady Fed Chairman in “The Egal has Crashed” much better than Bernanke.
I specifically wanted to stay away from a money-printer at the Fed, because that really changes the way a debt crisis plays out.
Country Thinker recently posted..The Fed Goes Political
You explained that very well, Ted. We are screwed…
Silverfiddle recently posted..Andrew Breitbart, RIP
My little boy turns 5 on the 19th. I have no choice to hope there’s a way out. But more and more I’m gearing toward preparation!
Country Thinker recently posted..The Fed Goes Political
You bring up a good point that I always miss when harping on these things even though it should be obvious to me. Which is that, besides the obvious problems of money printing, by artificially pushing interest rates down, the Fed artificially reduces retiree incomes (thanks to the lower rate of return). So not only are they forced to pay more dollars for what they need, they end up doing so on less dollars coming in. Talk about screwing retirees over.
Fed Chair under Nixon, Arthur F. Burns, summed up the Fed’s relation with politics in one sentence: “If the Fed doesn’t do what the president wants, it would lose its independence.“
theCL recently posted..Timothy Geithner Subpoena: May Face Criminal Charges
The double-edged sword of printing and low interest rates everyone on the lower end of the economic spectrum. If I could get OWS folks to understand this point, they’d see that the “1%” is a symptom, not the problem itself.
Country Thinker recently posted..At the End of the Tunnel—March 2, 2012
Oh, and I hadn’t heard that quote from Burns. That’s awesome, but frightening.
Country Thinker recently posted..At the End of the Tunnel—March 2, 2012