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dollar  economic growth  fed policy  fed  funds rate  funds  gold  inflation  liquidity  monetary base  policy  rate hikes  rate 
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Preview: RealClearPolitics - Articles - Wayne Jett and John Tamny

RealClearPolitics - Articles - Wayne Jett and John Tamny

Last Build Date: Thu, 01 Feb 2007 08:40:18 -0600

Copyright: Copyright 2007

Float the Fed Funds Rate

Thu, 01 Feb 2007 08:40:18 -0600

What's happening here? Rate hikes supposedly remove liquidity, which should increase the value of each remaining dollar. But demand for greenbacks fluctuates considerably, and when the Fed hikes the funds rate and raises the cost of capital, it reduces demand for liquidity. The rising gold price signals the Fed is actually increasing excess liquidity with each hike, not draining it. That the dollar is weakened by rate hikes will surprise some, but historical evidence confirms it. The dollar lost 67% against gold in 1972-1975 while the Fed hiked the funds rate from 3.5% to 13%. Similarly, the Fed funds rate rose from 5.25% in May, 1977, to 14% in February, 1980 (technically during the Volcker monetarism experiment after October, 1979), yet the dollar lost value from $150/oz to an all-time low against gold of $892/oz. Laffer Curve adherents should not be surprised that inflation is spurred by rate hikes. Just as a rising income tax rate drives the marginal producer to the sidelines, increased interest costs drain capital accounts and discourage productive investment by reducing profits. Dollar demand decreases and inflationary pressures increase when central bank actions cool economic growth. The dollar weakens as the economy weakens. Today's Fed increases the funds rate to produce higher unemployment, reasoning that this reduces upward pressure on prices from wages. But Milton Friedman persuaded most economists that inflation is "always and everywhere" solely monetary in nature, not a matter of wages and prices. Because the Fed sees jobs as purveying inflation, labor is robbed of its just rewards and society is deprived of essential signals of supply and demand. When labor is in short supply, higher wages perform the highly beneficial function of attracting more workers with better skills. The Fed's targeting of economic growth distorts price and wage signals that producers and workers use to decide where to invest and where to work. While chairman Bernanke awaited confirmation, he was reported to favor using "different tools" to implement Fed policy. At his confirmation hearings, he stressed an inflation strategy that is "very eclectic," involving use of "a wide range of indicators," including gold. Arthur Laffer recently opined that the Fed is already managing growth of the monetary base as its primary instrument of policy, and that the funds rate target is merely incidental. If this is so, the Fed will have truly sound policy if it adopts the proper aim in managing the monetary base. The aim should be a stable value for the dollar relative to gold. This would achieve high employment and economic growth, and would enable the Bernanke Fed to offer the world a dollar that serves as a stable unit of account - something the dollar-reliant world has lacked for 35 years. Laffer's interpretation of Fed practices may be off the mark. Through August 2006 (the most recent Fed data released), the Fed continued to inject new liquidity by buying Treasuries, $17.2 billion during the first eight months of the year. Moreover, on January 9, the Fed announced it "distributed" $28.5 billion to the Treasury during 2006 out of earnings on its portfolio. Thus, we know the Fed injected $45.7 billion during 2006 (plus net Treasury purchases during the last four months of the year). If Fed policy is to "tighten" liquidity, its operations are doing the opposite. Since the Fed creates dollars to buy Treasuries, destroying dollars earned as yield on those securities would be more consistent with tightened liquidity than giving them to the Treasury to spend. Monetary base management with a gold price target would eliminate inflation, not just retard it, and lower rates would be seen across the yield curve. The overnight rate the Fed has targeted in the past would float down to its normal place at the lowest point of the curve, rather than the highest point presently occupied. Labor and capital could enjoy fruits of toil without being targeted by Fed policy whenever prosperity appears. A target value for the dollar relativ[...]