Page 3 of 4 The Fed and the strong dollar policy
By Henry C K Liu
with foreign monetary authorities and with the market for the purpose of
stabilizing the value of the dollar relative to gold. In a public announcement
of this sale of gold by the ESF to the Treasury General Account, the Treasury
stated that the sale was made "in view of the likelihood that the Exchange
Stabilization Fund [would] not be engaging in further transactions to stabilize
the value of the dollar relative to gold". The ESF again had gold on its books
for a short period in 1978 as a counterpart to an ESF credit to Portugal.
Later in the 1970s, the US monetary authorities built up foreign currency
reserves substantially. For this purpose, the ESF entered into a $1 billion
swap agreement with the Bundesbank in
January 1978 (which has since been allowed to expire). In connection with the
dollar support program announced in November 1978, the Treasury issued foreign
currency-denominated securities (Carter bonds) in the Swiss and German capital
markets to acquire additional foreign currencies needed for sale in the market
through the ESF. The United States also drew on its reserve position in the
IMF.
Policy coordination
In the mid-1980s, the major industrial nations embarked on a process of
intensified policy coordination. The Group of Five's Plaza Agreement in
September 1985 served to reinforce exchange rate adjustments among the major
currencies and occasioned substantial coordinated intervention sales of
dollars. The G-5 "agreed that exchange rates should play a role in adjusting
external imbalances ... should better reflect fundamentals ... and that ...
some further orderly appreciation of non-dollar currencies against the dollar
is desirable."
In the Louvre Accord of February 1987, the major industrial countries agreed
that the exchange rate changes since the Plaza Agreement would "increasingly
contribute to reducing external imbalances and ... [had] brought their
currencies within ranges broadly consistent with underlying economic
fundamentals ... [and] agreed to cooperate closely to foster stability of
exchange rates around current levels."
They adopted specific measures and cooperative arrangements reflecting their
view that their currencies were broadly consistent with underlying economic
fundamentals. This framework for cooperation on exchange rates complemented the
broader economic policy coordination efforts to promote growth and external
adjustment. In December 1987, the Group of Seven reaffirmed Louvre's basic
objectives and policy directions and agreed to intensify their economic policy
coordination efforts and to cooperate closely on exchange markets. There was
continued active cooperation through late 1989, but such activities became less
frequent thereafter. Since the credit crisis of August 2007, because of the
dollar’s decline, talk of need for coordination has been revived.
In December 2007, as part of the measures to deal with the credit crisis, the
FOMC authorized temporary reciprocal currency arrangements (swap lines) with
the European Central Bank (ECB) and the Swiss National Bank (SNB), providing
dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB,
respectively, for use in their jurisdictions for a period of up to six months.
Today, in a globalized financial market of free floating exchange rates, the
exchange value of the dollar is a legitimate and necessary concern of monetary
policy. A hallmark of Fed structure is the inclusion of regional views and
sector conditions in formulating monetary policy.
From the beginning of the Fed in 1913, opinions, both economic and political,
have differed on the need for, and the location of geographic representation
on, the Fed Board of Governors. The debate has continued over the Fed’s market
participating arm, the FOMC, formed by the Banking Act of 1933, changed in the
Banking Act of 1935 to include the Board of Governors to closely resemble the
present-day FOMC composition, and amended in 1942 to the current voting
structure, which consists of the seven members of the Board of Governors, the
president of the New York Fed and four other Fed presidents who serve on a
rotating basis. In 1964, congressional hearings were even held to consider the
abolition of the FOMC on the argument that Fed open market operations were in
violation of free-market principles.
The Federal Reserve controls three tools of monetary policy: open market
operations, the discount rate and reserve requirements. The Board of Governors
is responsible for setting access qualification to the discount window to
borrow at the discount rate, as well as bank reserve requirements. The FOMC is
responsible for open market operations. Using the three tools, the Federal
Reserve influences the demand for, and supply of, balances that depository
institutions must hold at Federal Reserve Banks and in this way alters the
federal funds rate at which depository institutions lend balances at the
Federal Reserve to other depository institutions overnight.
Changes in the federal funds rate trigger a chain of market events that affect
other short-term interest rates, foreign exchange rates, long-term interest
rates, the amount of money and credit, and, ultimately, a range of economic
variables, including employment, output, and prices of goods and services. The
job of the FOMC is to set the fed funds rate target and keep the rate at or
near the target through open market operations in the repo market. A net
increase or decrease in reserves or liquidity in the banking system would also
put downward or upward pressure on the federal funds rate respectively.
Currency debasement
The Fed, a central bank, must still maintain a balance sheet that reconciles
its assets and liabilities just as any other bank does. While the Fed
theoretically commands unlimited credit through its power to print money, its
balance sheet is still subject to the same rules as any financial institution.
The difference is that instead of facing insolvency as a private bank would, a
weak Fed balance sheet causes debasement of the currency, since changes in
categories of Fed assets and liabilities are an important way the Fed
manipulates the money supply.
The Fed under Bernanke has recently taken action that changed the composition
of the Fed balance sheet, absorbing more mortgage bonds and swapping Treasuries
for even private-label and commercial mortgage-backed securities, in effect
influencing prices of securities tied to housing finance. These actions,
together with cuts in the fed funds rate target, have adversely affected the
exchange value of the dollar.
The importance and overriding dominance of national policy over regional and
sector considerations is now generally accepted. The FOMC is not expected to
adjust monetary policy to address economic concerns pertinent to only one
geographical district or one economic sector. In recent decades, until August
2008, regional and sector inputs had played increasingly only peripheral roles
in the formulation of national monetary policy.
By extension, the Fed as the institutional guardian of the dollar, the world's
prime reserve currency for international trade, is obliged to support the
Treasury's recent strong-dollar policy as a matter of national economic
security, as internationalist dominance in US policy over domestic concerns
became institutionalized. In recent decades, the rust belt and the agricultural
exporting states were urged to restructure their local economies to better
compete in the global market and not to expect a devaluation of the dollar to
bail them out of their economic problems. The Fed under Bernanke has deviated
from this path of a strong dollar in its response to the credit crisis of 2007.
Bernanke's June 3 speech on the dollar merely put the Fed back on track.
Financial markets are not the real economy but its early dawn shadow. The shape
and fidelity of that shadow are affected by the position and intensity of the
light source that comes from market sentiments on the future performance of the
economy and by the contour of the ground shaped by data on leading economic
indicators. Yet the institutional bias of the Fed over past decades has been
drifting toward more allegiance to the speculative effects on the financial
markets than to the health of the real economy, let alone the net benefit to
long-term investors or the welfare of all the people. Unfortunately, bending
the shadow to make it look tall does not alter the height of the subject.
Speculators rewarded
Granted, market economists argue that a sound financial market ultimately
serves the interest of all. But it is a hard sell to paint a debt-infested
economy as sound. The Fed's liquidity joy ride has been to reward speculators
rather than investors, and to favor transactions rather than growth. Further,
the economy is not homogenous throughout. In reality, some sectors of the
economy and segments of the population, through no fault of their own, may not,
and often do not, survive the down cycles to enjoy the long-term benefits, and
even if they should survive the down turn, they are permanently put in the
bottom heap of perpetual depression. Periodically, the Fed has failed to
distinguish a healthy growth in the economy from a speculative debt bubble in
the financial markets. There are clear signs that this failure has been
institutionalized at the Fed on Greenspan’s watch. The Bernanke Fed has yet
shown no signs of needed reform.
The Reagan administration (1981-89) by its second term, which began in 1985,
discovered an escape valve for its unprecedented fiscal deficit from Fed
chairman Paul Volcker's independent domestic policy of stable-valued money. In
an era of growing international trade among Cold War Western allies, with the
quasi-globalization incorporating the emerging economies before the final
collapse of the Soviet Bloc, a booming market for foreign exchange had
developing since Nixon in 1971 abandoned the Bretton Woods regime of
gold-backed fixed exchange rates.
The exchange value of the dollar thus became a matter of national economic
security and as such fell within the authority of the Treasury under the
president and required the "independent" Fed’s support as a patriotic duty.
Since that time, the Treasury has been the spokesman for the dollar, a fact
repeated only last February by Bernanke in Congressional testimony.
Council of Economic Advisors chairman Martin Feldstein, a highly respected
conservative economist from Harvard with a reputation
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