Are the recent actions of The Federal Reserve a demonstration of decisive, proactive action or a panicked, ill-considered attempt at rescuing undeserving speculators?
On March 11 2008 the US Federal Reserve pumped $200 million into the financial markets in a swap shop approach to bad debt, which will now see worthless mortgage debts (usually in the form of bonds) swapped for grade ‘A’ Federal Reserve bonds. Aside from the problems that the Federal Reserve has caused by removing all ‘Moral Hazard’ and consequence to lenders disgraceful actions, there is a very good reason why the money being pumped into the financial markets hasn’t been available until now and shouldn’t be made available at all.
By making vast amounts of credit available the Federal Reserve is adding new money into the system. Adding money into the pot is normally done in a controlled and careful way so as to not create inflation. Inflation is created this way because the volume of the assets compared to the amount of currency in the system has seen a dilution of each units worth. The GDP measure tells you how much your assets have increased each year and usually this will indicate how much more currency you can make available.
The problem with a $200 million dump of cash into the economy is that the total volume of the assets in the economy didn’t shoot up by $200 million on the 11th March. Instead the most recent data on the US economy shows that GDP is in fact likely to be below 1%, if any growth occurs at all, and this means that $200 million more cash is now represented by the same volume of assets as on the 10th March, resulting in a dilution of the cash-to-asset ratio. The more notes you print without a growth in assets to back them up, the less the currency is worth.
As the German’s found out after the First World War adding more currency doesn’t mean everyone is rich because they can get their hands on millions of Marks, or in this case millions of Dollars, it in fact means that the value of the notes is now worth less than before, and you will need to earn more and pay more just for the same amount of goods as you received previously. When you pay more for the same volume of goods as you did last time you made that same purchase, the increase is measured as a percentage and called ‘the rate of inflation’. As you can imagine the addition of $200 million out of nowhere will eventually have an impact on inflation.
The problem with this inflation is that it comes on the back of price led inflation already in the system from higher commodity prices such as gas, oil, electric and food. The next resulting move from the Federal Reserve would be to counter this inflation with an increase in interest rates. This would then be the worst possible situation, where the US economy has high inflation and high interest rates which would cause a major recession. The reason the interest rates were at 5.25% 12 months ago was to counter this evident inflationary pressure from commodities, but without this having disappeared the interest rates have been dropped to 2.25% and 200 million Dollars of inflation-creating money has been dumped into the economy.
This strategy smacks of desperation; all common sense has been thrown out of the window and the worst possible course of action is currently being taken. Rather than control inflation and keep this as low as possible, so the economy can recover quickly when the recession comes to an end, instead growth will be stifled as the Federal Reserve puts interest rates far higher than a recovering economy needs. The Federal Reserve are dealing with inflation caused when they decided to chase after the markets (lenders) mistakes in March 2008. The apt saying here is ’saving today at the expense of tomorrow’.
The worst part of this current move by the Federal Reserve to pump $200 million into the US economy is that it won’t save today but will definitely sacrifice tomorrow, because the inflation that is caused by this move will arrive before the benefits of a rate cut can feed through the system. The extra injection of cash these banks receive won’t save them so they can save everyone else when the recession comes, it will just save the banks, and it seems that the Federal Reserve and the investment banks have decided that a financial institutions survival is now more important than preventing a recession.
This short term approach by Ben Bernanke (Federal Reserve Chairman) and President Bush could be viewed more politically as avoiding a collapse into recession while a Republican is President, and once again just like after the last Bush Presidency in the 1980’s, leaves the Democratic President who follows with an economy in recession and a war to pay for. This may explain why the Federal Reserve are willing to run their current course of action, although I personally think that they are just to optimistic that they can do a quick fix, and recover the economy before inflation becomes a problem.
