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08.10.2011 0

Fed projects weak economy two years ahead

By Bill Wilson – In an unusual move, the Federal Reserve on Aug. 9 announced that it intended to keep the Federal Funds Rate — the rate at which the Fed and banks lend to each other — at near-zero “at least through mid-2013”.

The near-zero interest rates were instituted in Dec. 2008 as an emergency and, we thought, temporary measure to counteract the financial crisis.  They have remained near-zero ever since.

What made the announcement curious was the addition of a timeline, pushing off of any increase of rates until well after the 2012 elections.  Usually, the Fed simply announces its decision to keep rates where they are for an extended, non-specific period.

Instead, the inclusion of a timeline offers a rare glimpse of the Fed’s thinking.  Citing “economic growth so far this year has been considerably slower than the Committee had expected,” the move to announce an extended timeline for the Fed’s easy money lending policies means the central bank expects the economy to remain weak for at least the next two years.

Which means we’re not out of the woods yet.  Unemployment remains high, the housing market weak, and higher food and energy costs are draining household budgets.

Despite tripling its balance sheet since the crisis began in Aug. 2007 to more than $2.9 trillion, and Barack Obama’s trillion-dollar “stimulus” program, the economy is no better off than it was.  The Fed’s actions included a $1.25 trillion bailout to purchase mortgage-backed securities from financial institutions all around the world and increasing its treasuries holdings to over $1.6 trillion, making it the largest lender to the U.S. in the world.  But, to no avail.

As a result, the Fed is not taking QE3 off the table.  It wrote, “The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.”

For the uninitiated, the way the Fed traditionally will inject additional dollars into the economy is by printing money to lend to the federal government.   In doing so, the Fed helps keep the interest rates on U.S. treasuries relatively low, which, it thinks, is good for the economy.

The drawback, of course, was that was one of the main reasons the financial crisis happened in the first place, with the mortgage credit bubble being incentivized by interest rates that were kept too low for too long.

But, even worse than that, the Fed’s moves to buy treasuries speaks horribly to our creditworthiness.  We cannot even meet our obligations honestly.  Classical economist Adam Smith warned against such a “pretended payment” of debt, which he said was the equivalent of default.  In 2009 and 2010, Pimco estimates that the Fed bought some three-quarters of treasuries.

A trend that is likely to continue, QE3 or no.  The Fed is also continuing its program to sell back mortgage-backed securities it bought during the crisis and replace them with treasuries.  It has about $900 billion of breathing room left there to intervene by lending to Washington without adding to its balance sheet.

As a result, it is hard to say what treasuries rates might be if the central bank were not involved, except to say that rates would most probably be much, much higher.  S&P’s recent downgrade of the U.S. credit rating therefore has not even been fully felt by the markets yet.

But, as the fiscal situation in Washington continues to deteriorate, with the growth of debt far outpacing the anemic economic growth we are experiencing, we should expect more downgrades down the road.  Already, we are risking the dollar’s status as the world’s reserve currency, and the U.S. standing as the world’s economic superpower.

Eventually, the government in Washington will reach the true limit of borrowing, when the American people will no longer tolerate the destruction of their currency that comes with having the Fed print more money to pay the debt.  Then, interest rates will go to the moon.

One only hopes that by that time, Congress has found a way to balance the budget and begin paying down the debt honestly with revenues.  Otherwise, when the printing press is turned off, if the debt is so large it cannot possibly be repaid, an avowed default will be the only option left to the American people.

A central bank is no longer the path to prosperity.  And what Washington needs to learn is that it never was.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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