James Saft: How will the Fed dismount its tiger?


By James Saft
Friday, December 19, 2008


The Federal Reserve and U.S. economy have two considerable risks now that quantitative easing is at hand: keeping the dollar from a disorderly decline and figuring out how to dismount from the tiger.

The Fed has cut interest rates to a range of zero to 0.25 percent and said it would use "all available tools" to get the economy growing again, including buying mortgage debt as well as exploring direct purchases of Treasuries.

While the central bank was at pains to distance its policy from Japan's during its extended downturn, there can be no doubt that the dollar printing presses are and have been running and will pump out as much currency as is needed to avoid deflation and make credit available at a stimulative rate.

There is no question of the Fed not being able to re-ignite inflation in the U.S. economy; if they print money fast enough, prices will go up. The issue is more about the collateral damage possible when a major debtor nation takes these steps, even if it is doing it for all the right reasons in support of the best possible cause.

In the short term the risk is that foreign holders of the dollar and Treasuries are spooked by the whirring of the presses, and, reasoning that the Fed cannot fail in its quest to re-ignite inflation, decide to hold something less, well, risky.

Now of course in the current circumstances there may, for better or worse, not be that much of a dollar alternative for global reserve managers and investors and, seeing as how a rapid unwind in the dollar would hurt creditors, they may stick it out.

But the risk is higher now than last week, and much higher than earlier this year.

The value of a dollar against a trade-weighted basket of currencies fell sharply after the Fed’s announcement and is down about 10 percent in the past month.

Two factors that had been supporting the dollar through the recent months of the crisis, a tendency by U.S. investors to repatriate dollars during periods of stress and the need to purchase dollars as part of the process of unwinding leveraged financial trades, will not continue forever.

"The risks for the dollar are pretty clear," said Michael Hart, a foreign exchange strategist at Citigroup in London. "It is going one way and the only question is how uni-directional it is going to be and how many starts and stops we are going to see."

... It's diffeent this time

U.S. policy appears to be aimed at helping to recapitalize the banks and cutting the cost of finance to consumers by buying up assets and is distinct from that of the Bank of Japan, which increased bank reserves.

There are some key differences between the U.S. and Japan, which didn't have the same need to attract external finance, and for that matter between the U.S. now and the U.S. during the Great Depression. When the Depression struck, the U.S. was the world's biggest creditor, rather than its principle debtor.

The U.S. economy is both distended and hollowed out; it needs to redirect itself more toward savings and producing goods and services that can be sold overseas. The problem is that doing that quickly will be both very painful and produce a lot of collateral damage. Fed policy can only succeed if it softens the very terrible impact of that reallocation but does not prevent it.

But what happens if, or rather once, the Fed and the U.S. government's combined stimulus succeeds? How exactly do you unwind a program of Treasury and mortgage asset purchases and near zero rates without bringing on too much inflation, perhaps much too much?

If foreign holders of the dollar stick with it during the next crucial months, there is little to prevent them from bailing out later, if they judge the Fed to have kicked the ball too far down field. There is no way of knowing how this can be undone or what to expect.

There is also another set of actors who can cause problems; foreign central banks and their government bosses. If the dollar weakens much during a time of global recession many will have a hard time resisting the urge to devalue their own currencies in order to capture a bigger share of what little demand remains.

The plan to buy assets to cut the knot of finance is sound but begs the question of how and when the banking system will be brought back to life. I’m not sure that buying time and hoping it can outlive its debts will work.

The new administration needs to, quickly, enunciate a clear and comprehensive policy on how recapitalizations will work, so that private capital and taxpayers can know where they stand.


James Saft is a column for Reuters.

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