Federal Reserve policy risks catastrophic loss of confidence in the dollar

2012-DEC-14

The Federal Reserve confirmed on Wednesday what many expected: that come the end of Operation Twist at the end of this year – the scheme whereby the Fed sells its stock of short-term Treasuries in exchange for long-term Treasuries – it will print new money to buy long-dated Treasuries. Asset purchases will total $85 billion a month ($40 billion’s worth of mortgage-backed securities purchases, plus $45bn of long-dated Treasuries).

The FOMC noted that such purchases will continue until specific unemployment and inflation targets have been met. In its words:

“In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

The “at least” part is revealing: suggesting that such measures may well continue in the event that these targets are met. Consider also that for inflation to make any kind of serious dent in America’s debt burdens, it needs to hold up consistently at around 4-5% – meaning we can take the Fed’s 2.5% quote with a large grain of salt.

It also begs the question of how large the Fed’s balance sheet can get without it impacting confidence in the dollar – the Fed’s liability. The Fed currently owns a little under $3 trillion of assets, but buying at this rate will mean an increase of more than $2 trillion over the next two years. And up to $3 trillion by the end of 2015.

Does the concept of central bank accounting – as if they are just like any other bank – make any sense for institutions that can print as much new money as they see fit? And at what point does the shattering of this pretense lead to a dollar crisis?

Sooner than many people imagine we expect, but it depends on crowd psychology. Each time the Fed resorts to these ploys, it is slowly chipping away at the dollar “building’s” foundations. For a while, it may successfully be able to do this, without the building collapsing. But at some point, the building will collapse – and gold, silver, platinum and palladium and other hard asset prices will surge.