Economic Factor #2: Monetary Policy

  • January 31, 2017

    Monetary policy in the U.S. primarily reflects the current and prospective actions of the Federal Reserve with regard to money, interest rates and credit. The Federal Reserve Act of 1913 established the Federal Reserve system to provide the country with a sound banking and payments system and a stable currency. The power of the Federal Reserve has soared over the last 100 years and has led to a wider mandate that includes promoting economic growth and controlling inflation. More recently, the Federal Reserve is seen as the backstop of the entire economy.

     

    To be clear, the Federal Reserve Bank – and it alone – caused the horrible inflation crisis of the 1970s. Corporations did not cause it, unions did not cause it, oil prices did not cause it, and the Congress did not cause it. The Fed caused it. Having learned that lesson, the Fed has been careful to avoid a repeat of their terrible mistakes and the prospect for continued vigilance against high inflation remains relatively strong. To the extent that the Fed focuses on maintaining the reliability of the Federal banking system, keeping the dollar safe from high inflation and facilitating the smooth functioning of credit markets, there is substantial reason to see the U.S. monetary policy as a short-run positive.

     

    But Fed officials, like anyone else who has unbridled power over other people’s money, wants a bigger role. And in the financial crisis of 2007-2009, the Fed established its newest role: stabilizer of the entire economy. The Fed underwent a massive program of borrowing money to purchase risky and illiquid securities – resulting in a massive balance sheet. In effect , the Fed became the world’s biggest hedge fund.

     

    While I believe that in the short run the Fed is playing a very positive role in the U.S. economy, I see a very dark cloud on the horizon. The participants in the U.S. economy have developed confidence that the Fed can rescue a troubled economy. In the long run it cannot. At some point in the future, the “lender of last resort” will fail to be able to rescue the economy and the ensuing collapse will be cataclysmic. How should we prepare for this? We shouldn’t do much. I see this as improbable in the short run, impossible to avoid, and there is no good place to hide. In the meantime, I believe investors should keep the vast majority of their wealth in financial assets, even though at some point they will collapse while real assets thrive.

     

    Importance of factor in general: B+

    Prospective influence of this factor on the U.S. economy: B

     

    Click HERE for Economic Factor #1: Fiscal Policy

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