Pham Final

Federal Reserve $1.75 trillion Liquidity Plan

By Chinh Pham

Summary:

During this challenging time of financial problems and high unemployment, the Federal Reserve has taken unprecedented steps to increase the liquidity of the financial markets within the US by buying longer term government securities. Although these actions may solve today’s economic problems, the longer term impact of these actions could have major ramification to the US including high interest rate, high inflation, and long term weakness of the dollar. Given these problems, individuals that seek to preserve their capital should consider investing in TIPS, gold, and oil.

History of Federal Reserve

From 1791 to 1863 there are many different “bank notes” or paper money issued by different banks charter by states and private entities. In addition, there are also bank notes issued by the First Bank (1791 – 1811) and Second Bank (1816 – 1836), which were supposed to be paper money backed by the Federal Government. Within the US the multiple banks and multiple currencies were causing mass confusion.

From 1863 to 1913 the Federal Government established a system of National Banks to address the lending and the multiple currency problems under the National Bank Act of 1863. The National Bank Act allowed the Federal government then taxes all other states paper currency which effectively eliminated all other paper money except the Federal government.

From 1913 until present, the US needed a more flexibility to manage its money and to help prevent the major liquidity crisis that it occasionally faces. The Federal Reserve was established in 1913 under the Federal Reserve Act. The Act makes the Federal Reserve as the central bank of the US with the power to manage its money supply and control its interest rates [1].

Although both currency board and the central bank can issue paper money, the currency of a currency board is peg to a foreign currency while the currency of a central bank is dictated by supply and demand of the market due to its monetary policy. The currency board cannot change interest rates but only follow the interest rate of the peg currency. A country with a currency board monetary policy is dictated by what’s happening with the peg currency while central banks like the Federal Reserve manage the monetary policy of the nation [2].

The Problem

While the blame for the current credit financial crisis can be pointed to many groups (bankers, borrowers, speculators, poor government regulation, and lack of government oversights), one of the biggest cause has to be the Federal Reserve. By keeping short term interest extremely low for an extended period of time following the terrorist attack of September 11, this policy creates a global environment that’s starving for higher yield. As a result, massive amount of cash was poured into anything that promised higher return. Under that environment, many banks and investors became highly leverage and highly speculative to help meet the demand for higher yield. The result is a spectacular growth that is followed by an even more spectacular crash. The process to clean out all these bad bets or deleveraging around the world will be time consuming, extremely expensive, and very painful.

Although this bubble started with the subprime loan market and some bad mortgage loans, this problem has ballooned into the biggest credit crunch in the world history and is threatening to collapse the world banking system. This credit crunch has made it very difficult for borrowers to borrow money. This lack of available credit has caused one of the quickest and most severe recessions in recent history. Unlike past recessions, this recession affected virtually all sectors and all nations.

According to Bureau of Labor Statistics(BLS) since this recession begin in December 2007 until March 2009, the US has lost 5.1 million jobs in all sectors with two-third (3.2 million) lost in the five months between November 2008 and March 2009. As of March 2009, the nation unemployment rate is currently at 8.5 percent or 8.2 million people unemployed [3]. The current economic forecast is that the nation unemployment will rise to 10% (9.6 million people unemployed) by the by the end of the recession, which is expected at the end of 2009 or early 2010 [4].

On April 21, 2009, the International Monetary Fund (IMF) in its Global Financial Stability Report expected that the financial lost would be $4.1 trillion dollar (7 percent) out of $58 trillion dollars of asset originated in US, Europe, and Japan. The financial lost by region would be $2.712 trillion in US, $1.193 trillion in Europe, and $149 billion in Japan. At the end of 2008 banks have only written off one-third of this amount and the remaining will need to be written off during 2009/2010 [5].

Actions by the US Federal Reserve

As of April 2009 the US government and the Federal Reserve have lent, committed, or spent $12.8 trillion (90 percent of US GDP) to fight the global recession. However, one of the biggest issues with the current Fed activity is the increase use of its power to print money, particularly the buying of $1.75 trillion of longer term mortgage backed security and US Treasury [6]. This action have caused concerned both domestically and globally on the long term impacts on the US. The main concerns include:

• High Inflation
• High Interest Rate
• Long term weakening of the dollar
• Loss of US dollar as the world reserve currency

High Inflation / Hyper Inflation

Historically, inflation as measured by CPI within the US has been fairly mild. Since 1913 until 2008, inflation is averaging 3.43 percent [7] . This includes the lost years in 1970s where inflation was at a staggering 7 percent a year.

Exhibit 1 – Average Annual Inflation by Decade [7]

Exh1.jpg

With the current massive Federal budget deficit and the Federal Reserve plan to buy $1.75 trillion of longer term securities (GSE debt, GSE mortgage-backed securities, and US Government Bond purchases), there is a huge supply of money being printed and injected into the US and the world economy. There will also be more money being printed by the Fed to support the buying of additional US Treasury for the future $550 billion annual budget deficit from 2010 to 2014 [8].

During this recession, there is no inflationary pressure. Inflation as measured by CPI between March 2008 and March 2009 is at -.38 percent. At this time these actions taken by the Federal government and the Federal Reserve will not likely cause inflation. However, when this crisis is over and the economy returns to normal, there will be at least $1.75 trillion that is not there previously. This $1.75 trillion represents at 12.5 percent of a healthy US GDP [8].

The best known measure of the US money supply has been the M3 money supply as shown in Exhibit 2 [9]. Whenever the money supply M3 (green line) significantly increases, inflation (black line) quickly follows. Expanding money supply is the cause and the effect is inflation.

Exhibit 2 – Relationship between M3 money supply and Inflation [9]

Exh2.jpg

From basic economics, if the supply of money increases and the quantity of goods stays constant, then this is essentially a shift in the demand curve and the cost for goods will increase, i.e. inflation. Stated another way, if there are suddenly more money in circulation, then the value of each of those dollars will decrease.

If other trading nations kept their supply money growth more reasonable and the US significantly increases its supply of money, then the US dollar will likely significantly depreciate against other world currency. With the weaken dollar, import will cost a lot more. The increase cost of import will further drive inflation.

Using the past as a guide, past high inflation in the US can last as short as five consecutive years to as high as ten years. The average inflation in the US since 1913 has been about 3.43% per year but can increase by 2.5 to 4 times this amount in a period of high inflation.

Exhibit 3 High Consecutive Inflation Years in US [7]

Exh3.jpg

Since the Fed and the US governments are committed to massive budget deficit and significantly increase the money supply for the next several years, high inflation is inevitable.

High Interest Rate (Short and Long Term Interest Rate)

While the economy is in this recession, the Federal Reserve has lowered the Fed Fund Rate for short term interest rate to 0 to .25% [10]. For longer term interest rate, the Fed has also begun to purchase longer term US Treasury and mortgage back securities. The purchase by the Fed creates an artificial demand for these securities. As the Fed increases its purchase of these securities, the price for these securities will rise. There is an inverse relationship between bond price and bond yield. As bond price increases, bond yield decreases. The 10-year Treasury yield decreases from 5.1% in June 2007 to 2.82% in March 2009 while 30-year mortgage rate decreases from 6.7% in July 2007 to 5.0% in March 2009 [10].

The buying of longer term securities and the lowering the Fed Fund Rate resulted in the lower interest rates for both short term and long term securities and significantly increases the supply of money in the economy.

However, when the economy recovers and enters the high inflation period, the Fed will need to take drastic actions to stop high inflation. This will require reducing the money supply and increasing the interest rates. Essentially, the Fed will need to reverse all its policy in this recession.

Assuming that the US will only enter a very high inflationary period similar to the 1970s and similar past actions will be required to fix the problem, the Fed will need to increase its Fed Fund Rate from 0% currently to 19% (its rates in 1980/1981) [10]. To get rid of the excess money supply, the Fed will likely need to sell at least $1.75 trillion of the longer term securities for US treasury and mortgages. When the Fed sells these securities, this action will create a large supply of longer term securities which will significantly reduces its prices. When a bond price is significantly reduces, its yield will go up dramatically. In addition, this action will also take out at least $1.75 trillion from the economy or about 12% of the total money in circulation.

When the Fed begin to sell these longer term securities, longer term securities yield will dramatically increases. Assuming that the longer term security yields will rise only to the early 1980s level, 10-year US Treasury yield will rise from currently 2.82% to 15% while 30-year mortgage rate will rise from 5% to 19% [10]. Given the large amount of long term securities being dumped on the market, long term interest yield will be likely be higher than the early 1980s.
The net effect of substantially increasing the short term interest rate, substantially increasing the long term interest rate and the significant removal of the nation money supply will make it very difficult for consumers and business to borrow money. This will definitely put the nation into a deep recession. This recession will likely be much worse than the recession of 1980/1981.

Weakening of the US Dollar

The US has an expansionary money policy since the 1970s. However, since 2001 under former Fed chairman Alan Greenspan, the nation really increases its money supply as measured by M3 from $6.6 trillion in Jan 2000 to $10 trillion on Feb 2006 (the last official publish of M3 by the Fed). As the Fed increases the supply of dollar more than the demand for dollar, the US dollar depreciates against other major currencies.

From Exhibit 4 in early 2001 the Euro was trading at $.9232 per Euro. Until the current crisis, the Euro was trading at $1.5758 per Euro on July 2008. This means that the Euro appreciate by 71 percent against the US dollars in 7 years. When reviewing the US Dollar Index Exhibit 5 which compared the strength of the US dollars vs 6 major currencies (Euro (EUR), Yen (JPY), Cable (GBP), Loonie (CAD), Kronas (SEK), and Francs (CHF)) or 20 countries, the US dollar has decreased from 119.52 on July 2001 to a low of 72.25 on April 2008 or a weakening of 40%.

Exhibit 4 – Euro vs USD [11]

Exh4.jpg


Exhibit 5 – US Dollar Index [12]

Exh5.jpg

While the US dollar is already weak from its past policy, the Federal will further increase the money supply by at least $1.75 trillion with its purchase of longer term securities. This action when completed essentially significantly increases the US money supply by about 17 percent from its 2006 base of $10 trillion . With foreign demand for dollar stays the same or weak and supply of dollar significantly increases, the US dollar can only decrease against other foreign currency in the long run.

There two major impacts of a weak dollar would be inflation and higher cost of debts. As the US dollars weaken, import to the US, which currently at $2,520 billion or 17 percent of GDP, will cost more. This will further fuel inflation pressure to the US, which will further weaken the dollar.

The US is the world largest debtor nation with $5 trillion of public debt [8]. Foreign nations hold $3.162 trillion of US Treasury with China and Japan owning nearly half of all the foreign debt at $1.406 trillion [15]. As the dollar weakens, the value of these debt securities decreases and increases the loss of their investments. If the US dollar would lose 10 percent of its value, foreign nation would risk losing at least $316 billion by loaning money to the US.


Exhibit 6 - Foreign Holders of US Treasury [15]

Exh6.jpg

The longer term questions will be how long foreign nation will continue to lend money to the US as they see the US continues to drive down the value of their investments. If some if not many foreign nations decide that they have enough and begin to sell their holdings, this will increase the supply of dollars and will further weaken the US dollars. For other foreign nations who want to lend money to the US, they will demand higher interest rate to compensate their higher risks. This action will lead to higher long term interest rate in the US.

Loss of the US dollar as the world reserve currency

With the enormous size of the British Empire, the British pound sterling was the default world currency. However, after World War II, the US become the world super power and the US dollar replaces the British pound as the world currency. At its peak in 2001, the US dollar has a 72 percent share of the world total reserve [16].

There are two main advantages to having the US dollar as the world reserve currency. The first is the minimal exchange rate risk when doing international business. The US does not suffer the risk and cost of needing to exchange its currency like other nations. The second is that the being the world reserve currency allows the US to borrow debts at lower cost than other nations, which the US uses to its full advantage. However, as other nations look at the US macroeconomic problems, many are questioning if the US dollar would continue its dominance as the world reserve currency.

There are several criteria that need to be met for a nation’s currency to be considered as the world currency. They are share of the world trades, economic stability, strength of the currency, and global influence. Although there are many talks on what could replace the US dollars ranging from a basket of currency to the yen to the Euro, the only real replacement potential replacement in the foreseeable future would be the Euro.

Although the US stands alone as the world single largest economic nation, the Euro zone depending on the exchange rate would stand as the largest economy in the world. In 2001 the US dollar’s share of the world total reserve was 72 percent but that share was reduced to 66 percent by 2006. However, the Euro has increased its share from 18 percent in 1999 to 25 percent by 2006. Over time, the Euro zone can only become stronger and will continue to have a larger share of the world currency reserve [16].

When looking at the four key criteria for world currency between the US and the Euro zone, the Euro have three of the four criteria: larger share of the world trades, stronger economic stability, and stronger currency. However, at this time, the Euro zone lacks the global influence to become the world reserve currency. Since the Euro zone is composed of many nations, Euro zone hasn’t yet shown that it can come together in one voice and develop that one policy to promote its overall economic interest like the US. In addition, Euro zone countries have yet developed a strong military to protect its interest in a global scale. Alternatively, at this time, the US has the strongest military in the world and can use its military to protect its interest around the world. In time of problems, the US can and do make quick decisions (though not always good decisions) while Euro zone will continue to spend its time to come to consensus.

Given the difficulty of Euro zone coming to an agreement on key issues particularly key economics and military issues, it’s difficult to image how the Euro can over take the US dollar as the world reserve currency. Foreign nations will likely to continue to hold to US dollar not because of its faith in the US but because there are no real alternative. However, given the mass printing of money being done by the Fed, the US dollar will continue to weaken against other currencies. Until Euro zone can agree and act on key economics and military issues, the US dollar will continue to be the world reserve currency.

Corrective Actions

Due to the highly questionable behaviors by the Fed and the Federal government, the US is heading toward high inflation, high interest rates, and the weakening of the US dollar. To manage during this tough economic time, individuals should consider taking the following actions:

• Invest in TIPS for bond holders
• Invest in Gold
• Invest in Crude Oil

Exhibit 7 – Securities Potential in High Inflation Period [17]

Exh7.jpg

Invest in Treasury Inflation Protected Securities (TIPS) instead of regular US Government Bond

Under normal time, investing in US treasury has been a safe haven for bond investors. However, when the environment is high inflation for an extended period of time, US government bonds return a real return of negative 4.1 percent annually after adjusted for inflation. For protection of the principle with a reasonable amount of interest, individuals should purchase TIPS bond instead of regular US government bond. While the coupon of the bond stays the same, the principle is generally adjusted to CPI so the lender has some protection against inflation [17].

Invest in Gold

Given actions by various governments that will fuel inflations, gold provides an exceptional hedge to protect assets during high inflation periods. In the high inflation of the 1970s, gold was able to provide an annual real return of 13.7 percent. The best way to buy gold would be to purchase ETF funds or mutual funds that focus on gold [17].

Invest in Crude Oil

As inflation permeates the world economy, the price of crude oil will increase significantly. As long as there is no real alternative for oil, crude oil is an essential world commodity. People will continue to drive and travel. As a result, crude should and will maintain its value during this period. The average real return of crude during the high inflation period is 19.8 percent. The best way to purchase crude is either through ETF or mutual funds that invest in that sector [17].

Conclusion

With the world economy is going through a massive recession, the Federal Reserve has taken steps to fix the short term problems by injecting more money into the economy including the purchase of longer term government securities. However, these steps will likely lead to long period of high inflation, higher interest rates, and a weaken US dollars. Individuals wanting to protect their assets in this period should consider investing in TIPS, Gold, and Crude Oil.

Reference

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12. One Salient Oversight: US Dollar History Since 1973 <http://one-salient-oversight.blogspot.com/2008/02/us-dollar-history-since-1973.html> (Retrieve May 7, 2009)

13. "Money Stock Measure" Federal Reserve March 23, 2006 <http://www.federalreserve.gov/releases/h6/20060323/> (Retrieve May 7, 2009)

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15. "MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES" US Treasury Department February 2009 <http://www.treas.gov/tic/mfh.txt> (Retrieve May 7, 2009)

16. "The Dollar's Future as the World's Reserve Currency: The Challenge of the Euro" Open CRS July 10, 2007 <http://opencrs.com/document/RL34083> (Retrieve May 7, 2009)

17. Pryor, Austin, "Investing with rising Inflation in view" Sound Mind Investing May 2009, p 26

18. "MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES" US Treasury Department December 2007 <http://www.treas.gov/tic/mfhhis01.txt> (Retrieve May 7, 2009)

18. "MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES" US Treasury Department December 2007 <http://www.treas.gov/tic/mfhhis01.txt> (Retrieve May 7, 2009)

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