2010: A Year of Living Dangerously

The Federal Open Market Committee, a body of the Federal Reserve, voted this week to keep the federal funds rate in the range betwen 0% and 0.25%.

Frankly, I believe this to be irresponsible. It is part of the bad old tradition of using the money supply to stimulate an economy by cheapening the currency. They also retained the "extended period" language. You can see the whole statement by clicking that link.

The first two sentences of the 3d graph are crucial: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt."

This means full speed ahead for a policy of "quantitative easing," or the cheapening of the US dollar, and this in turn means increasing prices across the board are inevitable.

In the very short term, this is good news for some people. It is good news for businesses that have gone too far into debt, but whose debt is measured in nominal (non-inflation-adjusted) terms, because they'll be paying back that debt now in cheapened dollars, so in effect their debt is being reduced. It is good news, too, for some of hte unemployed. Some of those businesses, relieved of that debt, will be in a position to hire new employees. In simple terms, then, this policy will have and is having a stimulative effect, but it is like getting one's energy from a drug. The drug has effects on the body that go far deeper than the immediate rush, and even the rush won't be as great as some hope, because a body builds up tolerance over time, requiring ever-greater doses for the same effect.

Neal Lipschutz, managing editor of Dow Jones Newswires, expressed his disappointment immediately. "I continued to hope for the merest hint that zero rates can't go on forever. That would have been achieved by altering or eliminating the 'extended period' modifier for how long current policy would hold. But it stood unmolested."
Though Lipschutz didn't put it this bluntly, it does now appear that we are headed for 1970s-style stagflation.

The price of crude oil (which is globally set in terms of the US dollar) has been declining for the last month, from $80 to $70. Yet it began a climb immediately when markets learned that the FOMC was sticking with the near-zero rates and with the "extended period" description of their tenure.