US dollar hegemony

As World War II was coming to an end, 44 Allied nations met in July 1944 in New Hampshire, the US, to design a new set of  rules that would govern the post-war international monetary order.

1994:  Bretton Woods Conference

In 1944, the US dollar officially became the world's reserve currency.  The Bretton Woods Conference pegged all other currencies against the US dollar.  To ensure confidence in the system, the US dollar itself was convertible to gold at a fixed rate of US$35 an ounce.  The US at that time, held some three-quarters of the world's official gold reserves.

The system worked well enough in the initial years, on the back of robust demand for US goods and services from Europe and Japan for their post-war rebuilding efforts.

1960s:  Balance of payments crisis emerged

It started to fray  going into the 1960s, when European and Japanese exports became more competitive and the US share of world output declined.  Huge military spending during the Vietnam War further pushed the US into persistent deficits.  Demands for the US to balance its budget were ignored.

A balance of payments crisis emerged.  Official US dollar liabilities held overseas mounted, exceeding its gold stock multifold - the US dollar was overvalued.  By the second half of the 1960s, European nations demanded gold for their US dollar holdings, creating a run on US gold reserves.

1971:  End of Bretton Woods and end of gold convertibility

With rising inflation, unemployment, a weakening US dollar and the risk of running down all of its gold reserves, President Richard Nixon ended gold convertibility on Aug 15, 1971.  This also, effectively ended the Bretton Woods system.  He imposed a wage and price freeze to control inflation and levied import tariffs to boost US production and jobs.  The US dollar crashed and the world "stagflation" was coined.

The international monetary system transitioned from a gold standard to one based on pure fiat money, backed not by any underlying assets with intrinsic value but by faith in the US government.  It was due in  no small part, to the rise of "petrodollar" in the 1970s.

1974:  Rise of Petrodollar - "oil for dollars"

In 1974, Saudi Arabia made a deal with the Nixon administration that includes the condition that all its oil exports would be traded exclusively in US dollars.  This "oil for dollars" was later embraced by other by other members of the OPEC.  Given oil's critical importance in every economy, this all but cemented the US dollar's position as the pre-eminent medium of exchange as well as store of value.  The recycling of petrodollars into US dollar-denominated assets, including Treasury bonds, further anchored its reserve currency status.  

Over time, US dollar dominance extended to the entire commodities complex and the rest of the world.  Today, central banks typically hold about two-thirds of their foreign reserves in US dollar assets.

US enjoys an "exorbitant privilege".

US dollar as a world reserve currency allows US to enjoy an "exorbitant privilege".  

The insatiable demand for US dollar allowed the US to sustain the world's largest current account deficit, with no negative consequences.  The US is able to finance ever-growing fiscal spending with cheap borrowings - to keep building on its military superpower status, fortify its unparalleled influence in economics, finance and technology, pursue expansive social programs, support American consumerism and elevate living standards for its population, all the time compounding the positive feedback loop.  

Many believe that the US dollar hegemony has driven American foreign policy over the years.  This US exceptionalism was paid for largely by the rest of the world.  Its dominance is a legacy of the Bretton Woods system, which it created nearly eight decades ago.  Will this remain the case 20 years from now?

Reference:  Tong's Portfolio 2  Its all a matter of trust

The Day the Dollar Died

The first 12 hours of a U.S. dollar collapse! http://inflation.us

Soaring U.S. & Global Inflation

http://www.youtube.com/watch?v=2RaIRxBpTt0&feature=relmfu

http://www.youtube.com/watch?v=Ed4sv6ND5Qo&feature=endscreen

http://www.youtube.com/watch?v=2_xU9yD6x-0&feature=relmfu

23 Oct 2007

The Ultimate American Dollar Collapse

Gold is a perfect hedge against a falling US dollar. 22 Oct 2007

China buys gold, challenges US dollar

WikiLeaks cables allege that China is buying gold to weaken the US dollar's supremacy as the world's reserve currency.

China plans to let its currency trade freely on international markets by 2015 [EPA] China is shifting some of its massive foreign holdings into gold and away from the US dollar, undermining the dollar's role as the world's reserve currency, accoding to a recently released WikiLeaks cable. "They [the US and Europe] intend to weaken gold's function as an international reserve currency. They don’t want to see other countries turning to gold reserves instead of the US dollar or Euro," stated the 2009 cable, quoting Chinese Radio International. "China's increased gold reserves will thus act as a model and lead other countries towards reserving more gold." The cable is titled "China increases its gold reserves in order to kill two birds with one stone". Taken together with recent policy announcements from Chinese banking officials, it may signal moves by China to eventually replace the US dollar as the world's reserve currency. Last week, European business officials announced that China plans to make its currency, the yuan, fully convertible for trading on international markets by 2015. Zhou Xiaochuan, governor of China's central bank, said the offshore market for the yuan is "developing faster than we had imagined" but there is no definitive timetable for making the currency fully convertible. Presently, the yuan cannot be easily converted into other currencies, because of government restrictions. China's gold holdings are small compared to other major economies. It has 1,054 tonnes, the sixth-largest reserves in the world, according to data from the World Gold Council. Dollar's dilemma Buying gold and allowing the yuan to be traded freely would weaken the US dollar's dominance as the international reserve currency. The move would have major implications, making it more expensive for the US government to borrow money and to run perpetual trade and budget deficits. "The US is used to having the position of having the key reserve currency, but others are eager to replace it," said Josh Aizenman, a professor of economics at the University of California and president of the International Economics and Finance Society. As a reserve currency, the US dollar is the default for international transactions. If, for example, a South Korean company wants to buy wine from Chile, chances are they will carry out the transaction in dollars. Both companies must then purchase dollars to conduct their business, leading to greater demand. The value of global commodities, such as oil, is also generally demarcated in US dollars. Being a reserve currency allows the US to borrow at low interest rates, as central banks around the world are eager to buy US government debt. "Any country that can finance its expenditures by printing money or selling bonds is essentially getting a free lunch," Aizenman told Al Jazeera. With China's apparent change of heart, that "free lunch" now might come with a hefty tab. Given the massive US trade deficit, average Americans might be sent to the restaurant's kitchen to wash dishes if the dollar loses its status as the world's reserve currency. "China, until recently, was focusing on buying the US dollar through bonds," Aizeman said. Since the economic crisis, the US dollar has dropped compared to other major currencies, particularly the Swiss franc, Canadian dollar and Brazilian real. This leaves China in a bind, analysts said. Currency reserves In March 2011, China held $3.04tn US dollars in reserves, Xinhua news agenecy reported. It is the largest holder of US treasuries, or government debt, with $1.166tn as of June 30, 2011, according to the San Francisco Chronicle. Thus, major devaluation of the dollar would hurt China, as it would be left holding wads of worthless paper. "If you owe the bank $100, that's your problem. If you owe the bank $100m, that's the bank's problem," American industrialist Jean Paul Getty once remarked, in a parable that sums up China's predicament. "China is locked into a position where they cannot sell a big portion of their dollar reserves overnight without hurting themselves," Aizenman said. "It is too late for now to diversify rapidly the stock they have already accumulated." The answer: Buy gold. Everyone seems to be doing it. The value of the glistening commodity, useless for most practical purposes, increased almost 400 per cent, from less than $500 an ounce in 2005 to about $1,900 in September. "Gold has risen in value because of uncertainty in the world economy," said Mark Weisbrot, the co-director of the Centre for Economic and Policy Research, a think-tank in Washington. "Normally, gold would rise due to high inflation. It is a store of value that increases if there is inflation. But in this case it is going up because nobody knows where else to put their money." In the WikiLeaks cable, China alleged that "the US and Europe have always suppressed the rising price of gold", but neither Weisbrot or Aizenman think such a policy is taking place or even possible. Presently, China places strict controls on its currency, limiting foreigners from doing business in the yuan or trading it on foreign exchange markets. That could change in the next five years, according to governor Xiaochuan's recent announcement. By owning such large reserves of US currency, and through controlling the yuan, China can keep its currency lower than it would be if it floated freely. This makes Chinese exports cheaper. The relationship, in which Chinese investment in US government bonds allows low interest rates for Americans to buy Chinese products, has worked well for the last 15 years. In 2010, the US ran a $273.1bn trade deficit with China. "We pay our debts in dollars so we can print money to pay our international debts," Weisbrot told Al Jazeera. Because of the dollar's status as a reserve currency, the US "can run trade deficits indefinitely" while borrowing internationally without serious repercussions, giving the world's largest economy a "big advantage", he said. If gold, the yuan, or a combination of other currencies replaced the dollar, the US would lose that advantage. Without a replacement in the near term, nothing will replace the dollar as the world's reserve currency in the next five years at least. But nothing lasts forever. "When they [China] want the dollar to fall, they will let it," Weisbrot said. "The dollar will fall eventually but that could be a long time away." The fate of the dollar notwithstanding, a separate WikiLeaks cable outlines some of the broader ambiguities of the world's most important economic relationship, or "ChinAmerica", as it has been dubbed by historian Niall Ferguson. "No one in 1979 would have predicted that China would become the United States' most important relationship in thirty years," the cable stated. "No one today can predict with certainty where our relations with Beijing will be thirty years hence." http://english.aljazeera.net/indepth/features/2011/09/201199175046520396.html

Dollar hits global gains

May 11, 2011

Downside of strong dollar...global shares produced an average annual return of minus 4 per cent in the past decade.

Blame the terrible returns on international shares during the past decade on the Australian dollar. There was a dramatic dip in the value of the Australian dollar in 2008 and into early 2009, when sentiment about world economic growth was at its gloomiest, but otherwise it's been on a steady rise during those 10 years.

Most people access international shares through managed funds that allow the currency effects to flow through to investors.

The dollar's rise has more than sliced away the gains on overseas sharemarkets, leaving investors in the red.

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During the 10 years to the end of March this year, international shares have produced an average annual return of minus 4 per cent.

With losses compounding during such a long time, the original sum invested 10 years ago would be worth about half today, after accounting for inflation.

But the same portfolio, hedged or protected from exchange-rate fluctuations, has produced an average annual return of about 3 per cent during the same period. The difference between hedged and unhedged is 7 percentage points each year.

Investors could be excused for thinking they had invested in a foreign exchange fund rather than an international share fund.

About half the typical portfolio will be invested in US-listed shares, as the US makes up about half of capitalisation of developed-word sharemarkets. That means the US dollar is the currency exchange rate with the biggest impact on the returns of the unhedged portfolio of international shares. A decade ago, one Australian dollar was buying about US50¢. Last week it was buying more than $US1.10.

After 10 years of losses, many investors will be wondering what they should do now. Assuming they still want the diversification benefits of global shares, should they switch to a fund that removes the currency effects on their returns? During the next few years you would think the Australian dollar will stay high because of the resources boom keeping commodities prices high and Australian interest rates relatively high. Given the Australian dollar is so highly valued now, if there was to be a change in the value of our dollar, it is much more likely to be down than up.

If that is right, there may be nothing to gain from being in an international shares fund that removes the currency risk. There may be more to gain from leaving the international shares exposure unhedged to benefit from any dips in the value of the Australian dollar.

Another approach may be to include more exposure to emerging markets. The typical global shares fund has only a small exposure to emerging markets. But shares listed in China and India and other emerging countries are likely to keep doing well. Perhaps the best option is to consider managers who actively manage the currency risk, have a decent exposure to emerging markets and are not afraid to invest differently to their peers. This approach is more likely to be found among, but not limited to, boutique fund managers who specialise in managing global shares funds.

http://www.smh.com.au/money/super-and-funds/dollar-hits-global-gains-20110510-1eg2y.html

Exchange rate paradox occurring only in Vietnam

Last update 05/11/2010 05:17:23 PM (GMT+7)

Exchange rate paradox occurring only in Vietnam

VietNamNet Bridge – The greenback is losing its value against most other currencies in the world, but it is appreciating against the Vietnam dong. The exchange rate paradox is harming the national economy, forcing the government to apply urgent measures to stabilize the market.
Vietnam to use reserves, won't devalue 
The urgent government’s meeting on November 3 evening ended at 9 pm. Several measures were put forward to deal with the uncertainties on the forex market and prevent high inflation.

An unscheduled press conference was convened on the morning of November 4. Le Duc Thuy, Chair of the National Finance Supervision Council was assigned by the Government to inform the press about new policies on forex management. Representatives from the State Bank of Vietnam did not appear at the conference, where a series of new decisions relating to the monetary policies and forex management were announced.

The paradox only exists in Vietnam
The dollar price on the black market has been increasing continuously over the last two weeks, far exceeding the official exchange rate. On November 3, the dollar price once soared to 21,000 dong per dollar, much higher than the ceiling price of 19,500 dong per dollar.

Meanwhile, according to Thuy, the greenback has been losing its value against nearly all other currencies in the international market. In Russia, for example, ruble, not dollar, is required in making payment because people fear that the dollar will depreciate further.

Foreign experts said that with the loosened policy currently applied by the US Federal Reserves (FED), the dollar value would decrease by 20 percent in the time to come.

As such, a paradox exists: the gold price is increasing and the dollar price is decreasing in the world, while the gold price is increasing and the dollar price is also increasing in Vietnam

Overly high dollar credit growth rate is the “culprit”

Thuy said at the press conference that all macroeconomic indexes are very “beautiful”. The GDP growth rate may reach 6.7-6.8 percent, higher than the targeted level at 6.5 percent. The trade deficit would not be as high as previously thought, about 12.5 billion at maximum. 

Therefore, the high price of the dollar is a problem which needs to be solved.

According to Thuy, earlier this year, a lot of businesses rushed to borrow money in dollars. However, the problem was that they did not use the dollar, but they sold dollars on the market, thus causing an artificially high supply on the market. As a result, at that time the dollar price decreased and sometimes was even lower than the official exchange rate.

However, after that, businesses have to buy dollars to pay back debts, leading to increasing demand and the temporarily exhausted supply.

It is clear that to some extend, there exists the imbalance in dollar supply and demand. Besides, the prediction that the inflation rate in 2010 would exceed 8 percent has also made the Vietnam dong weaker.

Dong devaluation will not occur

In current circumstances, the move that people expect from the central bank is the further devaluation of the dong. However, the government has decided that Vietnam will not devalue the dong.

The Asia Development Bank has recently advised Vietnam not to adjust the exchange rate. Government officials have all agreed that adjusting the exchange rate at this moment is not a wise move and could even have very bad consequences.

The Vietnam dong has not become so weak that it is necessary to adjust the dong/dollar exchange rate. The dong devaluation also will not be a powerful tool to help boost exports. Especially, Vietnam is expecting to see exports increase significantly this year.

If Vietnam adjusts the exchange rate at this moment then it will send the inflation rate soaring. If so, the National Finance Supervision Council has estimated that the increase in the price of goods would be double-digits or more. Meanwhile, the top priority task for now is to obtain macroeconomic stability, especially, to control inflation. If the government fails to do that, people will lose their confidence.

However, the State Bank of Vietnam will take necessary measures to cool down the forex market. It will “pump” foreign currencies into circulation to ease the situation.

The announcement has raised the concern that this could make Vietnam’s foreign currency reserves become “thinner”. However, Thuy has reassured the public that the foreign currency reserves are sufficient enough. In the long term, Vietnam needs to increase its foreign currency reserves and will so when there are more favorable conditions.

Le Khac

http://english.vietnamnet.vn/en/business/1169/exchange-rate-paradox-occurring-only-in-vietnam.html

Gold and Silver Prices Signal the Destruction of the Dollar (video)

The age of the dollar is drawing to a close

The age of the dollar is drawing to a close
Currency competition is the only way to fix the world economy, says Jeremy Warner.

By Jeremy Warner
Published: 7:04AM GMT 05 Nov 2010

Dollar hegemony was itself a major cause of both the imbalances and the crisis Photo: BLOOMBERG

Right from the start of the financial crisis, it was apparent that one of its biggest long-term casualties would be the mighty dollar, and with it, very possibly, American economic hegemony. The process would take time – possibly a decade or more – but the starting gun had been fired.

At next week's meeting in Seoul of the G20's leaders, there will be no last rites – this hopelessly unwieldy exercise in global government wouldn't recognise a corpse if stood before it in a coffin – but it seems clear that this tragedy is already approaching its denouement.

To understand why, you have to go back to the origins of the credit crunch, which lay in the giant trade and capital imbalances that have long ruled the world economy. Over the past 20 years, the globe has become divided in highly dangerous ways into surplus and deficit nations: those that produced a surplus of goods and savings, and those that borrowed the savings to buy the goods.

It's a strange, Alice in Wonderland world that sees one of the planet's richest economies borrowing from one of the poorest to pay for goods way beyond the reach of the people actually producing them. But that process, in effect, came to define the relationship between America and China. The resulting credit-fuelled glut in productive capacity was almost bound to end in a corrective global recession, even without the unsustainable real-estate bubble that the excess of savings also produced. And sure enough, that's exactly what happened.

When politicians see a problem, especially one on this scale, they feel obliged to regulate it. But so far, they've been unable to make headway. This is mainly because the surplus nations are jealous defenders of their essentially mercantilist economic models. Exporting to the deficit nations has served them well, and they are reluctant to change.

Ironically, one effect of the policies adopted to fight the downturn has been to reinforce the imbalances. Fiscal and monetary stimulus in the US is sucking in imports at near-record levels. The fresh dose of quantitative easing announced this week by the Federal Reserve will only turn up the heat further.

What can be done? China won't accept the currency appreciation that might, in time, reduce the imbalances, for that would undermine the competitiveness of its export industries. In any case, it probably wouldn't do the trick: surplus nations have a habit of maintaining competitiveness even in the face of an appreciating currency.
Unable to tackle the problem through currency reform, the US has turned instead to the idea of measures to limit the imbalances directly, through monitoring nations' current accounts. This has already gained some traction with the G20, which has agreed to assess the proposal ahead of the meeting in Seoul. As a way of defusing hot-headed calls in the US for the imposition of import tariffs, the idea is very much to be welcomed, as a trade war would be a disaster for all concerned. China, for one, has embraced the concept with evident relief.

Unfortunately, the limits as proposed would be highly unlikely to solve the underlying problem. Similar rules have failed hopelessly to maintain fiscal discipline in the eurozone. What chance for a global equivalent on trade? With or without sanctions, the limits would be manipulated to death. And even if they weren't, the proposed 4 per cent cap on surpluses and deficits would only marginally affect the worst offenders: for a big economy, a trade gap of 4 per cent of GDP is still a massive number, easily capable of creating unsafe flows of surplus savings.


No, globally imposed regulation, even if it could rise above lowest-common-denominator impotence, is unlikely to solve the problem, although it might possibly stop it getting significantly worse. But what would certainly fix things would be the dollar's demise as the global reserve currency of choice.

As we now know, dollar hegemony was itself a major cause of both the imbalances and the crisis, for it allowed more or less unbounded borrowing by the US from the rest of the world, at very favourable rates. As long as the US remained far and away the world's dominant economy, a global system based on the dollar still made some sense. But America has squandered this advantage on credit-fuelled spending; with the developing world expected to represent more than half of the global economy within five years, dollar hegemony no longer makes any sense.

The rest of the world is now openly questioning the merits of a global currency whose value is governed by America's perceived domestic needs, while the growth that once underpinned confidence in its ability to repay its debts has never looked more fragile.

Already, there are calls for alternatives. Unwilling to wait for one, the world's central banks are beginning to diversify their currency reserves. This, in turn, will eventually exert its own form of market discipline on the US, whose ability to soak the rest of the world by issuing ever more greenbacks will be correspondingly harmed.

These are seismic changes, of a type not seen for a generation or more. I hate to end with a cliché, but we do indeed live in interesting times.


http://www.telegraph.co.uk/finance/comment/jeremy-warner/8111918/The-age-of-the-dollar-is-drawing-to-a-close.html

Fed Gets Aggressive After Months of Holding Back

ECONOMIC SCENE

By DAVID LEONHARDT

Published: November 3, 2010

For much of the last year, there were three basic camps on what theFederal Reserve should be doing.

Tim Shaffer/Reuters

Fed Chairman Ben Bernanke.

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Matthew Staver/Bloomberg News

Thomas Hoenig, president of the Kansas City Fed.

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One focused on the risks of the Fed’s taking more action to help the economy. This camp — known as the hawks, because of their vigilance against inflation — worried that the Fed could be sowing the seeds of future inflation and that any further action might cause global investors to panic.

Another camp — the doves — argued instead that the Fed had not done enough: inflation remained near zero, and unemployment near a 30-year high.

In the middle were Ben Bernanke and other top Fed officials, who struggled to make up their minds about who was correct. For months, they came down closer to the hawks and did little to help the economy. On Wednesday, they effectively acknowledged that they had made the wrong choice.

The risks of inaction have turned out to be the real problem.

The recovery has not been as strong as the Fed forecast. Businesses became more cautious about hiring after the European debt crisis in the spring. State governments began cutting workers around the same time, and the flow of federal stimulus money began to slow. Since May, the economy has lost 400,000 jobs.

Now — six months later, with Congress unlikely to spend more — the Fed is getting more aggressive. (And, yes, the idea that the doves are the advocates for aggression is indeed a bit odd.) Having long ago reduced its benchmark short-term interest rate to zero, the Fed will again begin buying bonds, as it did last year, to reduce long-term interest rates, like those on mortgages. Lower rates typically lead to more borrowing and spending by households and businesses.

Of course, the risks of taking action have not gone away. The new policy could eventually cause inflation to spike. All else equal, a policy that encourages more spending will cause prices to rise. And if investors begin to think that a dollar tomorrow will be worth much less than one today, they may refuse to lend money at low interest rates, undercutting the whole point of the bond purchases. Separately, the Fed, like any bond buyer, could end up losing money on the purchases, worsening the federal budget deficit.

What’s striking about the last six months, however, is how much more accurate the doves’ diagnosis of the economy has looked than the hawks’.

Early this year, for example, Thomas Hoenig, president of the Kansas City Fed and probably the most prominent hawk, gave a speech in Washington warning about the risks of an overheated economy and inflation. Mr. Hoenig suggested that the kind of severe inflation that the United States experienced in the 1970s or even that Germany did in the 1920s was a real possibility.

When he gave the speech, annual inflation was 2.7 percent. Today, it’s 1.1 percent.

The doves, on the other hand, pointed out that recoveries from financial crises tended to be weak because consumers and businesses were slow to resume spending. Around the world over the last century, the typical crisis caused the jobless rate to rise for almost five years, according to research by the economists Carmen Reinhart and Kenneth Rogoff. By that timetable, the unemployment rate would rise for a year and a half more.

Perhaps the clearest case for more action came from within the Fed itself. In June, an economist at the San Francisco Fed published a report analyzing how aggressive monetary policy should be, based on past policy and on the current levels of unemployment and inflation.

As a benchmark, it looked at the Fed’s effective interest rate, taking into account the actual short-term rate as well as any bond purchases to reduce long-term rates. Because the short-term rate was zero and the Fed bought bonds in 2009, the report judged the effective interest rate to be below zero — about negative 2 percent.

And what should the effective rate have been, based on the economy’s condition? Negative 5 percent, the analysis concluded. In other words, the Fed wasn’t buying enough bonds.

All the while, global investors have continued to show no signs of panicking. If anything, as the economy weakened over the summer, investors became more willing to lend money to the United States, viewing its economy as a safer bet than most others.

After the Fed’s announcement on Wednesday, many of the hawks who warned about inflation earlier this year repeated those warnings anew. The Cato Institute, citing a former vice president of the Dallas Fed, said the new program would “sink” the economy. Mr. Hoenig provided the lone vote inside the Fed against the bond purchases.

It’s always possible that the critics are correct and that, this time, inflation really is just around the corner. But there is still no good evidence of it. The better question may be whether the Fed is still behind the curve.

Some economists are optimistic that it has finally found the right balance. Manoj Pradhan, a global economist at Morgan Stanley, pointed out that bond purchase programs lifted growth in Europe and the United States last year — and a broadly similar approach also helped end the Great Depression. “There are no guarantees,” Mr. Pradhan said, “but the historical precedents certainly suggest it will work.”

Others, though, wonder if the program is both too late and too little. “I’m a little disappointed,” said Joseph Gagnon, a former Fed economist who has strongly argued for more action. The announced pace of bond purchases appears somewhat slower than Fed officials had recently been signaling, Mr. Gagnon added, which may explain why interest rates on 30-year bonds actually rose after the Fed announcement.

One thing seems undeniable: the Fed’s task is harder than it would have been six months ago. Businesses and consumers may now wonder if any new signs of recovery are another false dawn. And although Mr. Bernanke quietly credits the stimulus program last year with being a big help, more stimulus spending seems very unlikely now.

Unfortunately, in monetary policy, as in many other things, there are no do-overs.

http://www.nytimes.com/2010/11/04/business/04leonhardt.html?src=me&ref=business

Fed to Spend $600 Billion to Speed Up Recovery

Andrew Harrer/Bloomberg News

The Federal Reserve building in Washington.

By DAVID E. SANGER and SEWELL CHAN

Published: November 3, 2010

WASHINGTON — The Federal Reserve, getting ahead of the battles that will dominate national politics over the next two years, moved Wednesday to jolt the economy into recovery with a bold but risky plan to pump $600 billion into the banking system.

Interactive Feature

Timeline: The Activist Fed

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Loading Up on Treasuries

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The Swollen Balance Sheet

Bernanke Explanation of Fed Action (washingtonpost.com)

Related

• The Fed Discusses the Rationale for Its Securities Action(November 4, 2010)

• Economix Blog: Will Additional Fed Action Help the Economy?(November 3, 2010)

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Richard Drew/Associated Press

At the New York Stock Exchange on Wednesday, all eyes were on the Federal Reserve.

A day earlier, Republicans swept to a majority in the House on an antideficit platform, virtually guaranteeing that they would clash with the Obama administration over the best way to nurture a fragile recovery.

The action was the second time in a year that the Fed had ventured into new territory as it struggles to push down long-term interest rates to encourage borrowing and economic growth. In a statement, the Fed said it was acting because the recovery was “disappointingly slow,” and it left the door open to even more purchases of government securities next year.

The Fed is an independent body, its policy decisions separated from the political pressures of the day. But it acted with a clear understanding that the United States, like many other Western countries, seems to have taken off the table many of the options governments traditionally use to give their economies a kick, particularly deficit spending.

The Republicans regained control of the House for the first time in four years in part by attacking the stimulus plan — begun by the Bush administration and accelerated byPresident Obama — as a symbol of government spinning out of control, contributing to a dangerously escalating national debt.

This political reality has left Washington increasingly reliant on the Fed to take action, though its chairman, Ben S. Bernanke, has said the Fed cannot fix the problem alone.

But in stepping in so aggressively, the Fed is taking risks. The action not only expands the Fed’s huge portfolio ofTreasury bonds, it makes it a target of a Congress whose new members include some who are hostile to the Fed’s independent role.

On Wall Street, analysts said the move appeared to be a balancing act that met expectations and stock prices rose.

Ordinarily the Fed’s main tool for spurring economic growth is to lower short-term interest rates. But those rates are already near zero. With no more room to go, it has to find another route to stimulate demand.

That route is to buy government bonds, which increases demand for them and raises their prices, pushing long-term interest rates down. “Easier financial conditions will promote economic growth,” Mr. Bernanke predicted in an essay for Thursday’s Washington Post.

Representative Mike Pence of Indiana, the outgoing chairman of the House Republican Conference, said shortly after the announcement that the Fed was overstepping its bounds. “Diluting the value of the dollar by continually increasing the supply of money poses an incalculable risk,” he said. “Instead, Congress needs to embrace progrowth fiscal policies to stimulate our economy rather than masking our fundamental problems by artificially creating inflation.”

In making that argument, Mr. Pence and his allies are replaying a dispute that permeated Washington in the mid-1930s, when the economy was crawling out of the Great Depression. Conservative Democrats pushed Franklin D. Roosevelt to cut back on spending, and argued for tight monetary policy. Many economists argue that the result was a second downturn just before the outbreak of World War II, but others say the conditions today differ in so many ways that the comparison is misleading.

While the Fed step was telegraphed to the markets in recent weeks, most experts had expected $300 billion to $500 billion in purchases of Treasury debt. Still, the pace — $75 billion a month for eight months — disappointed some investors.

The Fed said it would also continue an earlier program, announced in August, of using proceeds from its mortgage-related holdings to buy additional Treasury debt, at a rate of about $35 billion a month, or $250 billion to $300 billion by the end of June.

So in total, the Fed will buy $850 billion to $900 billion, just about doubling the amount of Treasury debt it currently holds.

If the Fed’s bet is right, lower long-term rates should ripple through the markets, pushing down rates for mortgages and corporate bonds. That could encourage homeowners to refinance into cheaper mortgages, though it would not help the millions of Americans facing foreclosure. It could push businesses to make investments instead of sitting on piles of cash.

In a sign of its willingness to do even more, the Federal Open Market Committee, the central bank’s policy arm, left open the possibility of even more purchases beyond June, saying it would “adjust the program as needed to best foster maximum employment and price stability.”

Only one committee member dissented, for reasons that are similar to the complaints that some Republicans are likely to raise. Thomas M. Hoenig, an economist who is president of the Federal Reserve Bank of Kansas City, said he believed the decision could create more risk for the financial system by enticing too much borrowing.

There are other risks, as well. The actions are likely to further drive down the dollar. That could worsen trade and exchange-rate tensions that have threatened to unravel cooperation among the world’s biggest economies.

Moreover, the Fed is exposing itself to the risk that the assets it has acquired could shrivel in value when interest rates eventually rise. That could reduce the amount of money the central bank turns over to the Treasury each year, and expose the Fed, already vulnerable for its failure to prevent the 2008 financial crisis, to even more criticism.

On Wednesday, the standoff between the parties was on display as the two sides argued over tax cuts and the desirability of government investment to create jobs.

It was this impending gridlock that might have pushed Mr. Bernanke to move, said Laurence H. Meyer, a former Fed governor. “Bernanke has said that fiscal stimulus, accommodated by the Fed, is the single most powerful action the government can take for lowering the unemployment rate, when short-term rates are already at zero,” Mr. Meyer said. “He has nearly pleaded with Congress for fiscal stimulus, but he can’t count on it.”

But Leonard J. Santow, an economic consultant, said he feared that the Fed was reacting to one mistake — the failure of fiscal policy — by adding another. “The main problem is on the fiscal side, and there is nothing wrong with the Fed chairman making budget recommendations and admitting there is not a great deal left for monetary policy to achieve when it comes to stimulating the economy,” he said.

One of the main questions raised by the Fed’s action was whether it had waited too long. While economists disagree on that, the Fed’s announcement completed a U-turn. Earlier, speculation was that the Fed would gradually raise interest rates and tighten the supply of credit, as it would normally do after a recession..

But this downturn and its painful aftermath have been anything but normal. Markets were set back in the spring by the European debt crisis. By late summer, as continuing high unemployment, slow growth and low inflation became clear, Mr. Bernanke became convinced that the Fed needed to act again.

http://www.nytimes.com/2010/11/04/business/economy/04fed.html?src=me&ref=business