Keating: The Danger of Multi-Tasking at the Fed

August 26, 2014

By Maryann O. Keating, Ph.D.

The belief in tons of gold in Fort Knox backing the U.S. dollar is an illusion. There is absolutely no commodity backing for the dollar, either gold or silver or anything else. The dollar is accepted on faith; it is a “fiat” currency. This means that individuals accept the dollar in return for their labor, services or products because they trust those in authority to maintain its value. A rising price level erodes the value of the dollar.

If there is nothing like precious metal backing the dollar, then what does legal tender mean? It indicates that, according to U.S. law, all debts public and private can be paid with U.S. dollars — nothing more. U.S. courts will not support your right to be paid in a more valuable currency or in coins made of silver or gold.

The Federal Reserve System, referred to as the “Fed,” is responsible for maintaining the value of the dollar. The value of a dollar is what you are able to purchase in exchange for it. So, a dollar is worth a cheeseburger, or a small cone at McDonald’s, or about one-fifth of a bushel of corn, or, if you prefer, four quarters. Dollars held here and around the world are supported by the capacity of the U.S. to produce real goods and services that people can purchase. We expect the Fed to use its policy tools to guarantee that, in years to come, the average price of a designated basket of goods and services will not increase much beyond 2 percent a year. The 2-percent target appears, at this time, to be politically acceptable to the American public.

All this suggests that the role of the Fed is merely technical, not political. Economists are pretty much in agreement that, with some variation, a 2-percent yearly rate of inflation is feasible given close monitoring of price changes, of total money held by the non-bank public and of bank lending. The problem is that the Fed interprets its role as a dual one, not only to maintain the value of the dollar but in addition to maintain full employment.

Thus, whenever unemployment rises to an unacceptable level, such as above 6 percent, the Fed engages in expansionary monetary policy. This is designed to decrease the average level of the many interest rates prevailing in the economy. The belief is that lower interest rates stimulate consumer and business spending and lead to higher levels of employment and economic growth.

However, expansionary monetary policy, like keeping a foot on the gas pedal, has the potential of infusing too much liquidity into the economy, causing prices to increase. A sustained increase in the average price level is inflationary. What is the problem with inflation, though, if there is even a slight chance that expansionary monetary policy could increase employment and the production of goods and services?

In the short run, lowered interest rates and higher prices harm retirees living on their savings and others living on fixed incomes. Higher prices, as well, erode the financial wealth of all households. The long-run effects of hyperinflation are devastating to any financial system. Higher prices lead to expectations of even higher prices. Inflation diverts funds away from productive financial investments in machinery, plants and equipment and into precious real assets such as jewelry and paintings. No one wants to lend good money at low interest rates in return for a future payment with less purchasing power.

Inflation also affects international trade. If exchange rates with respect to international currencies are fixed, higher prices in the U.S. cause exports of corn and soybeans to decline. On the other hand, if and when the value of an inflating floating currency declines, the U.S. dollar price of imported intermediate goods, such as those needed for making recreational vehicles, soars.

At present, do prices in general seem to be increasing at more than 2 percent yearly? Is it taking longer to get quotes for household repairs? Is it plausible that historically low interest rates are designed to keep interest payments on the national debt down rather than to stimulate the economy?

Is it time for the Fed to take its foot off the gas pedal? Is it leading or following the market in determining interest rates?

You are not alone if you answer yes to these questions. Unfortunately, contractionary monetary policy to ward off inflation raises interest rates, lowers prices on outstanding bonds and can adversely affect the Stock Market. Taking away the punch bowl when the party is just getting started is not politically popular. Hesitation, though, only makes adjustment more difficult.

The painful effects of stop-and-go monetary policy are a result of asking the Fed to multitask. It should concentrate on maintaining the value of the dollar. The buck, literally, stops there.




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