After waiting on the runway for several months, the helicopter has finally taken off with US Federal Reserve chairman Ben Bernanke firmly in the pilot seat.
As he drops bundles of dollars from the copter, hoi polloi can stand ready out in the open to pick up the dollars as they waft in the air and come gently drifting down to the earth. No, strike that out. The dollar bills are going to come down in a torrent.
At a policy meeting last week, the open market committee of the Federal Reserve, or FOMC, pushed the overnight federal funds rate target down to the narrow, last corridor of 0-0.25%. Further, the committee signalled its intention to leave it languishing there for a while.
So, forecasters do not have to worry about getting their federal funds rate right for at least six to 12 months, if not longer.
The committee dwelt at length on the various debt securities the Federal Reserve could purchase, including the definite implementation of a term asset-backed securities loan facility to facilitate the extension of credit to households and small businesses. It is not clear if this would include provision of credit to households to pay monthly grocery bills. A colleague helpfully suggested that the Federal Reserve could issue its own credit cards and that it would save transaction costs.
With this announcement, the Federal Reserve has brought the curtains down on the always and ultimately unsustainable US dollar rally that was triggered by Bernanke’s speech on 3 June, in which he assured the world that he was attentive to the implications of change in the value of the dollar for inflation and inflation expectations. All that Bernanke’s concerns for the inflationary risks of the external value of the dollar achieved was to kill America’s exports and drag the rest of the world into a full-fledged crisis.
Hoping to undo that error of judgement, the world’s reserve currency managers have, for the umpteenth time, decided to fly solo and let the rest of the world figure out whether it should follow them in the race to the bottom or prefer to meet with some other equally unpleasant fate. The first time was in 1971-73 when President Richard Nixon closed the gold window and effectively ended gold-dollar convertibility at $35 per ounce. The second time was in 2001-03 when the nominal federal funds rate was brought down to 1%. Other countries followed, dictated partly by their own economic circumstances and partly by the anxiety to prevent excessive and rapid appreciation of their currencies. Consequently, the world was awash with easy money for too long.
The third time the Federal Reserve turned the US dollar spigots on was in the fourth quarter of 2007. It lit a fire to speculation in commodities, pushing crude oil price above $140 per barrel and many developing nations over the edge of the cliff.
This is the fourth time and the biggest solo flight of them all. None of the previous solo flights of the US Federal Reserve had a happy ending for the world economy and for world asset prices. We will leave it at that and let readers draw their own conclusions as to the ultimate success of this dangerous unilateralism on America’s part.
Not that Germany, the anchor currency of the European Monetary System (EMS), did better. In the 1990s, the political decision to engineer a German unification and to offer one West German mark in exchange for every East German mark triggered two speculative attacks on the EMS in two years as other countries needed lower and not higher interest rates that Germany needed to ward off inflation. A new global monetary standard with no country in anchor role will soon be needed.
With this FOMC decision, countries in the euro zone will be faced with a rapidly appreciating currency while the US engineers ludicrously easy monetary conditions for itself. They have to follow suit and prime their own monetary pump. Otherwise, the euro runs the risk of becoming as overvalued as it has become against the sterling.
Similarly, China has to face up to some crucial choices too. A weaker dollar will erode the value of China’s foreign exchange reserves. It will also focus the world’s attention on its fixings for the dollar-yuan exchange rate. The rise in the dollar in the last few months has contributed to a rise in the real and nominal effective exchange rate of the yuan. Now that the Fed has effectively signalled dollar debasement, China may not be able to continue with its undervalued exchange rate policy for long. That might yet be the only good thing to come out of this move by the Federal Reserve.
America has greatly enhanced the risk of “eye for an eye” economic policies next year.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer and Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at email@example.com