I find it odd that the Federal Reserve Bank isn’t worried about inflation. Nor is it worried about a falling U.S. dollar. The 1970s Federal Reserve Bank cared very much about the U.S. dollar, raising rates to the high double digits to curb inflation. On the contrary, the current Fed could care less.
The dollar “is not the goal” of monetary policy and is the “province” of the U.S. Treasury, Dudley said.
“If we do what we need to do in terms of achieving our dual mandate, the dollar will take care of itself,” Dudley said, referring to the central bank’s goals of full employment and price stability. “I don’t spend a lot of time focusing on the dollar.”
William Dudley, Vice Chairman and permanent voter of the FOMC, and president of the New York Federal Reserve at Cornell University on October 25th, 2010.
First of all, let’s clear up some confusion here. Mr. Dudley, your information is about 39 years old. The United States Treasury ended production of the United States Note in January 1971. The Federal Reserve note is the liability of the Federal Reserve Bank and the obligation of the United States Government. Here is an excerpt directly from the Treasury:
What are Federal Reserve notes and how are they different from United States notes?
Federal Reserve notes are legal tender currency notes. The twelve Federal Reserve Banks issue them into circulation pursuant to the Federal Reserve Act of 1913. A commercial bank belonging to the Federal Reserve System can obtain Federal Reserve notes from the Federal Reserve Bank in its district whenever it wishes. It must pay for them in full, dollar for dollar, by drawing down its account with its district Federal Reserve Bank.
Federal Reserve Banks obtain the notes from our Bureau of Engraving and Printing (BEP). It pays the BEP for the cost of producing the notes, which then become liabilities of the Federal Reserve Banks, and obligations of the United States Government.
Congress has specified that a Federal Reserve Bank must hold collateral equal in value to the Federal Reserve notes that the Bank receives. This collateral is chiefly gold certificates and United States securities. This provides backing for the note issue. The idea was that if the Congress dissolved the Federal Reserve System, the United States would take over the notes (liabilities). This would meet the requirements of Section 411, but the government would also take over the assets, which would be of equal value. Federal Reserve notes represent a first lien on all the assets of the Federal Reserve Banks, and on the collateral specifically held against them.
Federal Reserve notes are not redeemable in gold, silver or any other commodity, and receive no backing by anything. This has been the case since 1933. The notes have no value for themselves, but for what they will buy. In another sense, because they are legal tender, Federal Reserve notes are "backed" by all the goods and services in the economy.
The second part of the excerpt explains what a United States note is. I won’t quote that portion here, but it is an important read should you have the time. See link above. The key, however, is that the United States notes serve no function that is not already adequately served by the Federal Reserve notes, and none have been placed into circulation since 1971.
Now, let’s talk some more about the Federal Reserve Bank’s responsibility, since it seems somebody needs to hold them accountable. Federal Reserve notes are liablilities on the Fed’s balance sheet. As expressed above, Congress has specified that a Federal Reserve Bank must hold collateral equal in value to the Federal Reserve notes that the Bank receives – chiefly gold certificates and treasuries. What happened in 2009 when the Federal Reserve Bank purchased mortgage-backed securities, agency debt, and corporate bonds, was essentially a two-pronged attack on the U.S. dollar. 1) Degradation of the quality of assets on the balance sheet of the Federal Reserve, i.e. collateral backing your dollar. 2) Increased supply of liabilities by printing more dollars. If the Federal Reserve Bank was a stock company, they just diluted your shares. Sorry, they’re worth less now.
I don’t question that the U.S. was in a crisis in 2008 and 2009. Clearly it was and with rates near 0%, there was little left for the Federal Reserve to do to stimulate the financial system other than quantitative easing. I merely question, at what cost? And at what cost are we now considering a second wave of debt monetization (money printing) in QE 2.0. The Federal Reserve Bank believes there is no inflation. In the classical sense of the definition, money creation is inflationary. Whether it’s held back by the banks or not, more dollars have been created. That money creation will eventually permeate through the financial system. If it hasn’t, how is it that many goods have reached or surpassed their 2008 price levels – a time that deflationists and inflationist agreed we were experiencing high levels of inflation?
The Thomson Reuters/Jefferies CRB Spot Index can be divided into six sub-Indices. Here are their respective charts, source: Bloomberg. Click to enlarge.
Metals Sub-Index, Textiles Sub-Index
Raw Industrials Sub-Index, Foodstuffs Sub-Index
Fats & Oils Sub-Index, Livestock Sub-Index
I want to focus mainly on the CRB Raw Industrials Sub-Index because only 4 of the 13 components are traded on futures markets. That means the index is less influenced by speculative activity. Some of the components are burlap, butter, hides, hogs, gum rosin, and wool tops. Notice that index has surpassed the 2008 highs? This suggests the Fed might need to be more concerned about inflation.
Conclusion
Telling Cornell students and the press that the U.S. dollar is the province of the Treasury is like the pilot telling passengers the flight stability is the province of GE’s turbines. All he has to do is point the flight stick in the right direction and the plane will take care of itself. Rather, the pilot, the maintenance crew, and the flight attendants all have the responsibility to create a stable flight. The financial system is a big engine with trillions of moving parts that I don’t minutely presume to understand. What I do know, is that when the U.S. dollar falls, prices rise. The rising CRB Index is a mirror image of the falling dollar over the past 10 years.
In the 1960s, housewives were boycotting grocers due to high food costs. LBJ jumped on the opportunity to blame the “greedy grocers”. It didn’t take long for Republicans to reverse the blame on LBJ, pointing the cost for the Great Society came at the cost of higher price food and goods. This marked the first time in 36 years that Americans had come to terms with the costs of big government spending programs. The question lies with Americans today, will we continue to embark on a tax & spend way of life or will Americans realize that adding trillions in fiscal stimulus and increasing the Fed Balance Sheet in QE 1 and QE 2 will have repercussions. We may like the initial effects of inflation now – higher priced financial assets – but history has proven that this course has never ended well, especially for those without any financial assets to their name (house, portfolio, and/or business).
A strong dollar may not be the best policy right now, but a collapsed dollar isn’t either. The Bond King, Bill Gross, mentioned Monday that he anticipates another 20 percent decline to the U.S. dollar if the Federal Reserve continues this route. Do I think that QE 2 will work to fix the economy? Many economists believe it didn’t for Japan, so history hasn’t quite produced us a benevolent answer to that question. What I do know, is that many economic indicators have been ticking higher since this summer. How much is attributed to inflationary expectations is unknown. It may be that QE 2 will work, but the main question again is, at what cost –one, two, or even 5 years from now…
