Tight Money Threatens the Economic Outlook

Monetary policy in the U.S. has tightened, inadvertently, but with potentially dire consequences for the economy, employment and the stock market.  The source of tight money is a failure of the Fed to act in the face of a surge in the demand for dollars as individuals and corporations shift money balances out of the euro and into the dollar.

This episode is but the latest example of the cost of a monetary system that relies on the “best judgments” of a dozen voting members of the Federal Open Market Committee (FOMC) to set monetary policy. Without concrete rules and procedures that would permit monetary policy to adjust to the inevitable fluctuations in the demand for dollars as they occur, those in charge must wait for evidence in the real economy of either too much for too little money before they can arrive at a judgment as to what action to take next.  By then, the Fed is relegated to damage control from its own inaction.  The consequence is a more cyclical economy prone to financial crises.

The preponderance of evidence now points to a sudden and harsh reversal of inflationary pressures evident just a year ago, whipsawing commodity producers and adding monetary uncertainty to the existing impediments to economic growth in the U.S. and around the world.

Last June, the Fed’s second round of “quantitative easing” (QE2) was coming to an end. Over the prior eight months, the Fed had purchased $600 billion in assets, increasing the monetary base or supply of money by 33% above its year earlier level.

Such an increase in the supply of dollars in the face of steady demand led to a fall in the value of the dollar.  Over those same twelve months, commodity prices as measured by the CRB spot commodities index were up 34%. Metals prices were up 37%, oil up 28% and foodstuffs up an incredible 45%.

But, when QE2 stopped, the Fed virtually stopped growing the monetary base. As a consequence, the year-over-year increases began to fall, hitting 29% at the end of December.  By March, the 12-month change had dropped to 16%. By the end of May, the monetary base was virtually unchanged from its June 2011 level.

A zero increase in the supply of money may have been fine had not the European financial crisis intensified over the same period.  As confidence in the sovereign debt of spread from Greece to Spain, Portugal and Italy fell, so did trust in the stability of banks stuffed with government bonds and the stability of the euro itself.   The latest concerns over Greece and now Spanish banks has intensified the flight to the dollar.

If you hold the quantity of a good constant in the face of rising demand, the price of that good goes up.  The same is true for the value of a currency.  In the past year, the value of the dollar has gone up – 16% against the euro. The year/year change in the CRB spot commodity index is now minus 14%.  The dollar price of metals and foodstuffs have fallen 17% and oil prices have dropped 15% to under $85 a barrel.

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