THE FEDERAL RESERVE MUST CHANGE ITS WAY IN THIS NEW ECONOMIC ERA / SEEKING ALPHA

The Federal Reserve Must Change Its Ways In This New Economic Era

 

by: John M. Mason

Summary

 

The Federal Reserve states that it has two policy goals, high employment and low inflation, but this has not been true for forty years or more.

        

What the Federal Reserve does has major implications in international markets and this cannot be ignored anymore.

       

It is time for officials at the Fed to face up to this and to inform the public that this is the case...and the sooner it does this, the better.

Has the United States, and the world, entered an era in which the Federal Reserve can no longer concentrate on just its own economy?

As Janet Yellen and the Federal Reserve continue to tell us, the two primary objectives of the monetary policy is to achieve high rates of employment and low rates of inflation for the United States.

Yet, at the press conference Fed Chair Janet Yellen held, where Ms. Yellen announced that the Federal Reserve was holding its target interest rate constant, China was mentioned several times and the problems emerging markets were having was also mentioned.

In fact, Roger Blitz and Jennifer Hughes write in the Financial Times about how Ms. Yellen was "rankled" about the Chinese as "she highlighted global concerns" but focused how China had managed its recent devaluation.

But concerns over emerging markets were making headlines as well; notice on the front page of the print Financial Times the lead "Alert on Emerging Markets Crisis and US Slowdown Despite Fed Rate Decision." The article speaks of hedge fund operator John Burbank "whose Passport Capital has placed a number of lucrative bets against commodities and emerging markets this year…"

The Federal Reserve cannot just focus upon the state of the domestic economy. But this begs the question because the United States has had major impacts on world markets going back to the late 1960s when inflation began to get out of hand because of the Keynesian stimulation originally begun during the Kennedy administration and carried through the Johnson and Nixon administrations.

The credit inflation at that time resulted in the floating of the US dollar and the destruction of the Bretton Woods system upon which the post-World War II era was based. Then, in the 1980s, after the credit tightening of the Paul Volcker-led Federal Reserve, some major international disruptions took place, particularly in Latin America.

In the 1994-95 period, there was the Asian crisis associated with movements at the Federal Reserve.

Paul Volcker, in his rehash of his time of involvement at the Fed, the Treasury, and as a consultant, claimed that the price of a country's currency in foreign exchange markets the most important price in that country's economy. See his book, "Changing Fortunes."

The Fed's importance in international finance during the recovery from the Great Recession cannot be ignored. During the first round of quantitative easing, most of the reserves the Fed pumped into the US banking system stayed there. But, in the second round of quantitative easing, the situation changed dramatically.

At that time, November 2010, the reserve balances of commercial banks at the Fed totaled just under $1.0 trillion. By the end of the third round of quantitative easing, October 2014, these reserve balances totaled over $2.7 trillion.

Parallel with this movement, we see on the Fed's H.8 release that cash balances on the books of commercial banks amounted to $1.1 billion at the earlier date and $2.9 billion at the later date.

Note: Cash assets at foreign-related institutions totaled $357 billion in November 2010, roughly one-third of the total cash assets in the US banking system. In October 2014, cash assets in foreign-related institutions amounted to $1.451 trillion, or almost fifty percent of the total cash assets of the US banking system.

But, listen to this. The "net deposits due to foreign-related offices" of these foreign-related institutions in the United States went from a negative $390 billion in November 2010 to a positive $584 billion in October 2014, an increase of almost $1.0 trillion.

While the Fed increased cash assets at banks in the US by $1.8 trillion over this time period, foreign-related institutions took $1.0 trillion offshore. And, during this time, commodities markets boomed and emerging market economies and securities took off. So did the value of their currencies in foreign-exchange markets.

Now, cash assets at commercial banks in the US have dropped in August 2015, but only to $2.731 trillion. Of these monies, the cash assets of foreign-related institutions dropped to $1.168 trillion or about 42 percent of total cash assets. "Net deposits due to foreign-related offices" have fallen to just $345 billion.

The point is that the Federal Reserve is heavily involved in foreign-related transactions and can be closely connected with events that are taking place in the foreign exchange markets. Yet, it has no explicit objectives in these areas.

Whatever the Fed does in the near future, it will have significant effects on world markets and the prices of currencies. George Magnus, senior economic advisor at UBS, writes about how long the Fed should be impacted by what is going on in China. Magnus questions "how long should the Fed cite China or emerging markets as a reason for keeping rates on hold, especially if the domestic case for not doing so becomes even more compelling?"

Mr. Magnus continues "If the Fed continued with financial market stability as the leitmotif of policy-making, a later but more disruptive policy adjustment and greater instability are the all too likely outcomes."

The Federal Reserve is not going to be able to ignore what is going on financially or economically in the world. It is not going to be able to just focus on domestic factors and it needs to stop kidding itself…and the world that this is the only game it is in.

This is the reality of the situation and, whether or not the Fed likes it, the international markets are going to be playing an even more important role in future Fed policy-making. It needs to grab hold of this reality and then it needs to make sure that the rest of the world knows about this reality as well.

A world engaged in currency wars benefits no one.