New Congress should rein in the Fed

12:03 PM, Nov 13, 2010   |    comments
  • Share
  • Print
  • - A A A +

More than anything else, voters confirmed in the midterm elections that they distrust the ruling class in Washington. It is not just the fiscal and regulatory uncertainties created by the executive and congressional branches' two major legislative accomplishments - ObamaCare and the financial regulations reform - that have unnerved Americans. It is also the easy money monetary policy being pursued by the Federal Reserve. In fact it is hard to remember a time when fiscal and monetary policy were at such contradictory odds, with the former putting the brakes on the economy and the latter pressing the accelerator to the floor. Separately, each of these is harmful. Together, they are reckless.

Regardless of party affiliation, citizens have good reason to distrust Washington power brokers who are reluctant to learn from past mistakes rather than applying common sense to solve problems and sustain financial stability and prosperity.

After all, it was the easy credit from Fannie, Freddie and the Federal Reserve under the control of Washington policymakers - which encouraged lax lending and underwriting by banks and Wall Street - that ultimately resulted in financial collapse and wholesale destruction of wealth, from which it will take years to recover. Rep. Barney Frank, D-Mass. - the congressional caretaker of Fannie/Freddie - was just re-elected, and more than two years after becoming insolvent, Fannie and Freddie remain on taxpayer life support at a cost of $150 billion and counting with no cure in sight. Indeed, in the more than 2,000 pages in the new financial regulations, these housing behemoths escaped unscathed, left on the congressional to-do list. Amazing.

A dangerous path

Notwithstanding the recent election results, Washington remains on a path that risks a financial Armageddon. Federal Reserve Chairman Ben Bernanke has chosen to ignore the evidence that 12 months of a 1% federal funds rate in 2003-04 contributed to the housing bubble and subsequent collapse. He still shows no inclination to raise short-term interest rates, even after maintaining a 0% federal funds rate for nearly two years. He speaks of the threat of deflation, but gives little heed to signals from commodity and currency prices, which are reliable indicators of inflation.

It is not just oil prices approaching $90-$100 a barrel and new highs in the precious metals that are clear warning signs of a new inflating bubble. It is also the broad basket of commodities that includes copper, rubber, wheat, oats, pork, coffee, sugar and cotton - all of which are up more than 50% in the past 12 months - that is sounding the inflation alarm.

How can it be otherwise? When manufacturers' costs rise, which is already reflected in significantly higher material inputs and producer prices, inflation of consumer prices cannot be too far behind. And how can prices not rise for a nation that imports more than it exports when it pursues a relentless devaluation of its currency? With the U.S. dollar probing new lows in world markets, American consumers are sure to face higher prices.

The inflation and devaluation that will drive interest rates higher to compensate for lost dollar value have negative implications for the American consumer in terms of wealth and purchasing power erosion. But the more serious consequences from the Fed's pursuit of debt monetization and currency printing in a second round of quantitative easing - dubbed QE2 - is nothing short of moving ever closer to an insolvency crisis, one that would destroy the dollar and usher in global financial chaos. A shocking thought for sure, but here's how it could unfold.

The death spiral

When investors conclude that inflation and devaluation make holding U.S. Treasury debt unattractive, they will demand higher offsetting coupon rates. Today, the blended cost of funding the U.S. debt of more than $13.7 trillion is about 2.5%, the lowest in over 50 years. Normalization and modest inflation could easily drive Uncle Sam's borrowing costs back up to about 5% - double the current cost, but a manageable increase.

However, a crisis in confidence - triggered by either a failed U.S. Treasury auction or a recognition of the Fed's balance sheet having grown too large for orderly liquidation except at fire sale prices - would cause an immediate spike up in bond yields and interest rates. The cost of servicing the U.S. government's debt service would increase many fold, setting in motion a downward spiraling liquidity crisis ending with the U.S government unable to finance its obligations.

Is QE2 primarily a stimulus? Or is it a liquidity dodge necessary to monetize U.S. government debt issuance that the Chinese and foreigners are no longer willing to buy? In any case, unlike Greece that was rescued by an infusion of capital from Germany and the European community, no one will be able to bail out the United States if the tipping point of crisis is reached.

Which brings us back to those election results.

The first order of business for the new Congress is two-fold: move on deficit and debt reduction and rein in the Federal Reserve. Voters across the U.S. have sent a clear message, and a more engaged citizenry and Tea Party watchdogs intend to hold Washington accountable as never before. It's time to seize the day - for tomorrow may be too late.

Scott S. Powell is a visiting fellow at the Hoover Institution and a managing partner at RemingtonRand Corp. and Alpha Quest.

By Scott S. Powell

Most Watched Videos