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The Fed Has Forgotten Sound Money, And Now Just Manipulates Interest Rates

Posted by
August 22, 2012
in Blog

by James Dorn

While some members of Congress and Republican presidential hopeful Mitt Romney want to label China a “currency manipulator,” little is said about the Federal Reserve’s role as an interest-rate manipulator.  Interest rates are relative prices that should be freely determined in private capital markets, not manipulated by the central bank.  The Fed is now an allocator of credit, not a trustee of sound money.

In 2008, the Federal Reserve started on a path that has resulted in a near-zero Fed funds target, which is expected to last through 2014.  The Fed has also engaged in two rounds of quantitative easing that have more than doubled the size of its balance sheet, acquiring more than $2.5 trillion of Treasury debt and mortgage-backed securities.  Most recently, the Fed extended its “Operation Twist,” in which it sells short-term Treasuries and buys longer-term securities with the goal of reducing long-term rates.

 

Although the stated intention of the Fed’s low-interest policy is to stimulate economic growth, the U.S. economy is still sluggish and unemployment stubbornly high.   A more politically motivated goal is to assist the Treasury in funding the massive U.S. public debt, which is expected to increase by nearly $10 trillion over the next decade.  Last year the Fed bought more than 60 percent of newly issued Treasury securities.

The Fed’s dual mandate requires gearing monetary policy toward maintaining full employment and price stability, but the Fed is ill-equipped to have much influence on real GDP growth, which is best left to entrepreneurs and markets.  Indeed, common sense tells us that printing money does not create new wealth—just look at what happened in Zimbabwe.  Moreover, a host of economic research has shown there is no long-run (and perhaps no short-run) tradeoff between inflation and unemployment.  Instead, the stagflation of the 1970s revealed that high and variable inflation causes unemployment to rise and growth to slow.

In its statement from the June19–20 meeting of the Federal Open Market Committee, the Fed reported that “to support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy.”  By which the FOMC meant keeping the Fed funds rate at “exceptionally low levels . . . at least through late 2014.”  The Fed also stated that it was “prepared to take further action as appropriate to promote a stronger economic recovery.”  The only dissenting member was Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond.

The presumption is that the Fed can promote economic growth through easy money and “exceptionally low” interest rates.  More likely, the Fed is creating another asset bubble, this time in the bond markets.  Treasury yields are at historic lows.  The quest for higher yields is inflating a bubble in junk bonds, and investors are taking on more risk as they try to improve their performance…

Continue reading at forbes.com…