Briefing: The Power of the Fed

With the economy teetering on recession, the nation’s central bank recently took the unprecedented step of lowering interest rates twice in three weeks. How does the Fed influence interest rates, the economy—and your life?

The Week Daily reports:

What exactly does the Fed do?

It operates like a big dam, regulating the flow of money into the economy. The Fed’s goal is to prevent both “droughts’’—recessions—and “floods’’—inflation. Congress created the Federal Reserve System in 1913, after a string of bank collapses battered the economy and stripped millions of people of their life savings. Today the Fed—a network of 12 government banks spread across the country—is responsible for keeping prices stable and long-term interest rates moderate. That may sound arcane, but the Fed’s machinations affect everything from the price of home loans to whether the economy is adding jobs or losing them. When the Fed manages the economy well, said former Fed official Robert McTeer, “fewer people go to prison, more are healthier because they can afford to take better care of themselves, even the environment gets better taken care of.”

How does the Fed have such a huge impact?

It all stems from its ability to manipulate how much money is available to businesses and individuals seeking loans. When the Fed wants to lower rates, it buys billions of dollars worth of government-backed bonds, thereby pumping money into the banking system. The increased availability of money reduces its cost—that is, the rate of interest. To raise rates, the Fed sells securities, which drains money from the system. By tinkering with rates, the Fed can tighten or loosen the amount of money coursing through the economy. Last August, when bond and stock markets were on the brink of a meltdown, the Fed cut the Fed funds rate by a quarter-point, which pumped $38 billion into the banking system. That reassured investors, who sent the stock indexes soaring, which calmed consumer jitters—at least for a while. “The Fed’s control over the money supply,” said Gregory Mankiw, a former economic advisor to President Bush, “is a powerful lever to move overall demand for goods and services.”

How does the Fed set its rates?

It’s a murky process mostly done in private. The decision to raise or lower rates is made by the Federal Open Market Committee, which includes the Fed chairman, Ben Bernanke, and five regional Fed officials. The panel makes an assessment of the economy, weighing everything from unemployment levels and retail sales to housing starts and manufacturing output. If the economy seems to be slowing, it can cut rates to encourage borrowing and spending. If the economy is overheating, it can raise rates to reduce the risk of inflation. It’s an inexact science. “Policy makers must rely on estimates,” says a Fed publication, “aware that they could act on the basis of misleading information.” The Fed rarely reveals what specific data guided a particular decision, which bothers critics. “The nation pays a terrible price for allowing this cloistered governing institution to evade serious public scrutiny,” said William Greider, author of a critical book on the Fed.

Whom does the Fed answer to?

Pretty much nobody. By design, the Fed is insulated from politics. Its top officials are presidential appointees, but they have staggered terms, so no one president can pack the bank with loyalists. The Fed is funded with interest on the accounts it controls, so Congress can’t use the budget to punish it. But this doesn’t mean the Fed is apolitical. In early 1972, a presidential election year, inflation was accelerating, usually a signal for the Fed to raise rates. Instead, then—Fed Chairman Arthur Burns, formerly a top aide to President Richard Nixon, kept rates low. “The policy helped re-elect the president,” said historian Allen Matusow, “but also assured the next cycle of boom and bust.” In 2001, then–Fed Chairman Alan Greenspan was roundly criticized by Democrats when he said that he did not believe President Bush’s proposed tax cuts would lead to a budget deficit. He turned out to be wrong, but not before he swayed many wavering lawmakers to support Bush’s plan.

Do rate cuts always have their intended effect?

Hardly, and the current financial situation may be a case in point. Banks seldom hesitate to pass on their higher borrowing costs to customers. But they’re not always so quick to share lower costs. Since the Fed’s most recent cuts, corporate loan rates have actually increased, by about 1.25 points, and banks and credit card companies have on average raised, not lowered, the rates they charge consumers. That’s probably because banks are trying to make up for the massive losses they’ve incurred in the mortgage crisis, by borrowing at low rates from the Fed and lending at higher rates to businesses and consumers.

Is there anything the Fed can do about that?

No. The Fed can’t order banks to make loans or lower rates. The Fed, in fact, may be quietly encouraging banks to raise their rates, some analysts say, hoping that this strategy will help banks shore up their mortgage-battered finances. But banks can’t make money on high-priced loans that no one wants. With the economy slowing, consumers are spending and borrowing much less. Businesses, in turn, have less motivation to build new stores and plants and stock up on inventory. When rate cuts fail to stimulate demand for new loans, as is currently the case, the Fed is said to be “pushing on a string.” Given the economy’s rapid deterioration, the Fed may be pushing for some time.

Sinking Currency, Sinking Country

Pat Buchanan writes:

The euro, worth 83 cents in the early George W. Bush years, is at $1.45.

The British pound is back up over $2, the highest level since the Carter era. The Canadian dollar, which used to be worth 65 cents, is worth more than the U.S. dollar for the first time in half a century.

Oil is over $90 a barrel. Gold, down to $260 an ounce not so long ago, has hit $800.

Have gold, silver, oil, the euro, the pound and the Canadian dollar all suddenly soared in value in just a few years?

Nope. The dollar has plummeted in value, more so in Bush's term than during any comparable period of U.S. history. Indeed, Bush is presiding over a worldwide abandonment of the American dollar.
Is it all Bush's fault? Nope.

The dollar is plunging because America has been living beyond her means, borrowing $2 billion a day from foreign nations to maintain her standard of living and to sustain the American Imperium.

The prime suspect in the death of the dollar is the massive trade deficits America has run up, some $5 trillion in total since the passage of NAFTA and the creation of the World Trade Organization in 1994.

In 2006, that U.S. trade deficit hit $764 billion. The current account deficit, which includes the trade deficit, plus the net outflow of interest, dividends, capital gains and foreign aid, hit $857 billion, 6.5 percent of GDP. As some of us have been writing for years, such deficits are unsustainable and must lead to a decline of the dollar.

A sinking dollar means a poorer nation, and a sinking currency has historically been the mark of a sinking country. And a superpower with a sinking currency is a contradiction in terms.

What does this mean for America and Americans?

As nations realize that the dollars they are being paid for their products cannot buy in the world markets what they once did, they will demand more dollars for those goods. This will mean rising prices for the imports on which America has become more dependent than we have been since before the Civil War.

U.S. tourists traveling to the countries whence their ancestors came will find that the money they saved up does not go as far as they thought.

U.S. soldiers stationed overseas will find the cost of rent, gasoline, food, clothing and dining out takes larger and larger bites out of their paychecks. The people those U.S. soldiers defend will be demanding more and more of their money.

U.S. diplomats stationed overseas, students and businessmen are already facing tougher times.

U.S. foreign aid does not go as far as it did. And there is an element of comedy in seeing the United States going to Beijing to borrow dollars, thus putting our children deeper in debt, to send still more foreign aid to African despots who routinely vote the Chinese line at the United Nations.

The Chinese, whose currency is tied to the dollar, and Japan will continue, as long as they can, to keep their currencies low against the dollar. For the Asians think long term, and their goals are strategic.

China — growing at 10 percent a year for two decades and now growing at close to 12 percent — is willing to take losses in the value of the dollars it holds to keep the U.S. technology, factories and jobs pouring in, as their exports capture America's markets from U.S. producers.

The Japanese will take some loss in the value of their dollar hoard to take down Chrysler, Ford and GM, and capture the U.S. auto market as they captured our TV, camera and computer chip markets.

Asians understand that what is important is not who consumes the apples, but who owns the orchard.

Other nations that have kept cash reserves in U.S. Treasury bonds and T-bills are watching the value of these assets sink. Not fools, they will begin, as many already have, to divest and diversify, taking in fewer dollars and more euros and yen. As more nations abandon the dollar, its decline will continue.

The oil-producing and exporting nations, with trade surpluses, like China, have also begun to take the stash of dollars they have and stuff them into sovereign wealth funds, and use these immense and growing funds to buy up real assets in the United States — investment banks and American companies.

Nor is there any end in sight to the sinking of the dollar. For, as foreigners demand more dollars for the oil and goods they sell us, the trade deficit will not fall. And as the U.S. government prints more and more dollars to cover the budget deficits that stretch out — with the coming retirement of the baby boomers — all the way to the horizon, the value of the dollar will fall. And as Ben Bernanke at the Fed tries to keep interest rates low, to keep the U.S. economy from sputtering out in the credit crunch, the value of the dollar will fall.

The chickens of free trade are coming home to roost.

It's Still the Economy, Stupid

In Washington, the big worry for presidential hopefuls is who benefits most from an election-year recession

Jimmy Carter still blames the fierce squeeze on household incomes in 1979 for his loss of the White House to Ronald Reagan in 1980.

In the New Statesman, Alex Brummer writes:

Almost every town of any size in the United States, from the towers of New York through the Great Plains to the burning shoreline of California, has a Merrill Lynch office on the corner. The "retail" stockbroker is an understated but ever-present feature of the American landscape. So imagine the shock to the system when Americans woke up recently to find that this blue-blooded symbol of US capitalism had miscalculated so badly that it was being forced to declare an $8bn loss and reveal that its very existence as an independent financial house was threatened.

US consumers and households are becoming more used to surprises. The earthquake that began in America's trailer parks, where over-enthusiastic "realtors" - the equivalent of our sharp-suited estate agents - persuaded people to buy into the dream of home ownership, irrespective of their incomes, has spread further and wider than anyone could ever have anticipated. It has rocked financial markets around the world, sent America's housing market (along with cars, one of the two great pillars of US growth) grinding to a halt and propelled the construction industry into premature depression.

All attention is focused on the Federal Reserve, America's central bank. Like an outfielder in the World Series, it is seeking to catch the ball and throw it to base to save the game. It is rapidly reducing interest rates and pumping cash into the wholesale money markets, where banks lend to each other, in the hope that it can prevent the real economy of growth and jobs crashing to the ground.

Running the Federal Reserve, in the run up to an American election campaign, is a tricky business as the chairman, the bearded former Princeton academic Ben Bernanke, is learning. Jimmy Carter still blames the fierce squeeze on household incomes in 1979 for his loss of the White House to Ronald Reagan in 1980. George Bush Snr holds a grudge against his fellow Republican Alan Greenspan, the former Fed chairman, for keeping interest rates too high in 1992 and handing the election to Democrat Bill Clinton.

Now, once again, the White House and the economy are hanging in the balance at the same time. As the first tests of strength in Iowa and New Hampshire loom into view at the turn of the year, the big question is can the US avoid an election year recession? The candidates will be monitoring events closely. There will be no presidential or vice-presidential incumbent in the White House to take the blame for economic failure in 2008. But economic uncertainty has almost always favoured the opposition down the decades, dating back to Franklin D Roosevelt's election during the Great Depression.

Failure to halt the economic slide between now and November next year potentially could sound the death knell for the hopes of any Republican nominee (Iraq notwithstanding). This would be true even if it turns out to be the present frontrunner, the social and economic liberal, Rudolph Giuliani.

Commercial turbulence could be the ace in the hole for Democratic frontrunner Hillary Clinton, who in some polls is a commanding 33 percentage points ahead of her nearest competitor, Barack Obama. In large conservative swaths of the country, the Clinton name is still surrounded with dark suspicion and salacious gossip. Yet in the area of economic competence, the Clinton family reputation is unsullied. Bill Clinton's 1992 election slogan - "It is the economy, stupid" - was not just an empty gesture.

As Greenspan recalls in his memoir, The Age of Turbulence, Bill Clinton understood the need to keep budgets close to balance if long-term interest rates were to be kept low and stability and growth maintained.

An endorsement from Greenspan is as good as it gets and Hillary must count on some of the Bill glow reflecting on her in hard economic times.

Repossessions

So how bad is it going to be for the American economy? Clearly, the crisis in the housing market will be key. The ridiculous lending practices of the past few years, particularly in fast-growth southern and western states, is now reaping a bitter harvest. Payments on an estimated 5 per cent of all mortgages and 15 per cent of sub-prime mortgages (the low quality loans to people who can barely afford them) are already delinquent. Whereas in Britain foreclosure and repossession is a relatively calm and careful process, in the US it can be brutal, with the bailiffs ruthlessly seizing assets. RealTrac, which monitors this process, reckons that up to 1.5 million homes will go through the process this year. In parts of the US, notably Florida and the counties east of Los Angeles, the market is already being flooded with repossessed properties. This surplus means that new housebuilding is grinding to a halt as prices in parts of the country plummet. In its just published World Economic Outlook report, the International Monetary Fund notes that "the correction in the US housing sector has now been underway for two years and has been a major drag on activity". It calculates that thus far it has wiped 1 per cent off American growth and reckons that there is much more to come. As well as the direct impact on construction, residential homes are key to consumption. When house prices are stable and rising, the consumer feels more confident and better off - the "wealth effect". Take that away and consumer confidence tumbles.

But in this crisis there is an extra dimension. Because of the way rotten mortgages were packaged up as securities, spread around the financial system and sold on to investors by intermediaries - such as Merrill Lynch - the housing crisis has triggered a credit squeeze. In a country as dependent on borrowing as the US this has a dramatic impact, with the car market among the sectors already affected. Surveys are showing plunging factory output. The IMF warns that against the background of a "more general deterioration in the labour-market conditions or a sustained drop in the stock market, risks of recession have increased".

The better news about an American recession in the present decade, should it occur, is that it will possibly have less of an impact on our own economy and the rest of the world than in the past. One of the key debates currently taking place in Washington and Wall Street is the question of how far the US economy has become "decoupled" from the rest of the world. The theory is that with some 50 per cent of global production now in the emerging market economies, such as China, India and Brazil, the world is far less dependent on the US to keep it growing.

This analysis carefully skirts around the issue of the American consumer who, on some measures, still accounts for up to 17 per cent of worldwide spending. If US households close up shop then the factories that supply them will also suffer.

Credit chaos

This is not all. No country is more dependent on imported oil than the United States. In recent weeks the market price of oil has escalated, reaching $90 a barrel, raising the price of petrol at US pumps and heating fuel prices as the US readies itself for a heavy winter. Higher oil prices act as a tax on the consumer limiting budgets for other products, raising the cost of production for industry and slowing the wheels of commerce. Add to all this uncertainty the weakness of the dollar, the chaos in credit markets and nervousness on Wall Street and you have all the ingredients for financial meltdown.

President George W Bush and his treasury secretary may worry about all of this but they have precious little time and room to manoeuvre. They could seek, for instance, to persuade the Chinese to lower the value of their currency, the renminbi, which would ease pressure on the dollar. They can also take a tougher approach to spending bills sent to them by Congress, in the hope that this will help ease long-term interest rates and constipation in the money markets.

But the real power to change things rests not at the White House, at this late stage of an eight-year presidency, but a few blocks away at the grand headquarters of the Federal Reserve. The present incumbent has already shown an awareness of the potential problems by cutting interest rates sharply by a half point and offering banks all the credit they need to keep the economy moving. Bernanke, thought to have Republican sympathies, will not want to be accused of aiding and abetting a recession in the run-up to next year's presidential election. Nor will he want to take a risk with inflation at a time when commodity prices, led by oil, wheat and steel, are surging globally.

Yet in his hands - like those of his august predecessors Paul Volcker and Greenspan - lies not just the fate of the US and global economies, but potentially the outcome of the 2008 presidential election.

US economy crisis in numbers:

$1.43 value of dollar against the euro on 26 October - an all-time low

4.7% unemployment rate, the highest in over a year

1.5 million number of families who may lose their homes as a result of the crisis

23.3% drop in house sales compared to last year - sales hit a record low

6% average drop in house prices over the past six months, the worst housing slump in 16 years

$2.3bn quarterly loss at Merrill Lynch, the biggest loss in its 93-year history

93% drop in quarterly profits at Bank of America's corporate and investment banking division

Fears of Dollar Collapse as Saudis Take Fright

The Telegraph reports:

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East.

Ben Bernanke has placed the dollar in a dangerous situation, say analysts

"This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

"Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.

As a close ally of the US, Riyadh has so far tried to stick to the peg, but the link is now destabilising its own economy.

The Fed's dramatic half point cut to 4.75pc yesterday has already caused a plunge in the world dollar index to a fifteen year low, touching with weakest level ever against the mighty euro at just under $1.40.

There is now a growing danger that global investors will start to shun the US bond markets. The latest US government data on foreign holdings released this week show a collapse in purchases of US bonds from $97bn to just $19bn in July, with outright net sales of US Treasuries.

The danger is that this could now accelerate as the yield gap between the United States and the rest of the world narrows rapidly, leaving America starved of foreign capital flows needed to cover its current account deficit - expected to reach $850bn this year, or 6.5pc of GDP.

Mr Redeker said foreign investors have been gradually pulling out of the long-term US debt markets, leaving the dollar dependent on short-term funding. Foreigners have funded 25pc to 30pc of America's credit and short-term paper markets over the last two years.

"They were willing to provide the money when rates were paying nicely, but why bear the risk in these dramatically changed circumstances? We think that a fall in dollar to $1.50 against the euro is not out of the question at all by the first quarter of 2008," he said.

"This is nothing like the situation in 1998 when the crisis was in Asia, but the US was booming. This time the US itself is the problem," he said.

Mr Redeker said the biggest danger for the dollar is that falling US rates will at some point trigger a reversal yen "carry trade", causing massive flows from the US back to Japan.

Jim Rogers, the commodity king and former partner of George Soros, said the Federal Reserve was playing with fire by cutting rates so aggressively at a time when the dollar was already under pressure.

The risk is that flight from US bonds could push up the long-term yields that form the base price of credit for most mortgages, the driving the property market into even deeper crisis.

"If Ben Bernanke starts running those printing presses even faster than he's already doing, we are going to have a serious recession. The dollar's going to collapse, the bond market's going to collapse. There's going to be a lot of problems," he said.

The Federal Reserve, however, clearly calculates the risk of a sudden downturn is now so great that the it outweighs dangers of a dollar slide.

Former Fed chief Alan Greenspan said this week that house prices may fall by "double digits" as the subprime crisis bites harder, prompting households to cut back sharply on spending.

For Saudi Arabia, the dollar peg has clearly become a liability. Inflation has risen to 4pc and the M3 broad money supply is surging at 22pc.

The pressures are even worse in other parts of the Gulf. The United Arab Emirates now faces inflation of 9.3pc, a 20-year high. In Qatar it has reached 13pc.

Kuwait became the first of the oil sheikhdoms to break its dollar peg in May, a move that has begun to rein in rampant money supply growth.