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November 10, 2011

Armageddon for the US Dollar?

Inflation is real, it is here, and it will likely continue to be an issue investors and consumers will have to deal with for the foreseeable future. As prices for goods and services rise over time the purchasing power of our…

Armageddon for the US Dollar?

Inflation is real, it is here, and it will likely continue to be an issue investors and consumers will have to deal with for the foreseeable future. As prices for goods and services rise over time the purchasing power of our pay checks and our investment returns are unfortunately eroded. We are either left with a much smaller safety net each month or worse, are forced to make tough decisions about what we buy given that our dollars just don’t go as far as they used to.

It is hard to turn on the television, listen to talk radio, or read any of the headlines from the multitude of finance related
internet blogs without being inundated with this impending “inflation crisis” or the even more dramatic, “complete and utter demise of the US Dollar.” But let’s take a moment to back away from the media’s playful hysteria and really, truly evaluate the claims that the US Dollar is headed toward its untimely demise.

It is true that over the last few years the Federal Reserve has operated their “printing presses” at abnormally high rates, dramatically expanding the supply of US Dollars in the hopes of stemming the crushing blows dealt to the US and global economies by The Great Recession. For all of the econ majors out there like me, this is a simple supply and demand issue,
right? More dollars chasing the same amount of goods causes prices to rise. A huge increase in the supply of money should then cause an avalanche of price escalations.

We’ve seen it before in places like Zimbabwe, Argentina, and the Soviet Union – these images of children carrying buckets of paper currency to the market in the hopes of simply buying a loaf of bread for their family back home. Is this disastrous scenario on the horizon for Americans as we too deal with our government’s zeal to right the economic ship which led them to bloat our domestic monetary supply?

I for one don’t think so and I’ll tell you why. I said at the beginning of my comments: Inflation is real and it is here. What I don’t believe is that we are headed down a path toward hyper-inflation and the eventual Armageddon of the US Dollar.

Perception versus Reality

How many of you would really know that the Fed went on this money-printing spree if it had not been broadcast to the heavens by the media? I’m going to guess probably not too many of you.

Second question: Does it feel like the credit markets have are back to normal and financing is once again widely available? I sure don’t.

The Fed may have vastly expanded their borrowing in order to provide much needed liquidity to our domestic banking system. This is quite true. The question is, have those banks actually turned to the public to begin circulating those new found dollars through mortgages, small business loans, lines of credit, or any other means of putting those dollars to use out in the
general economy?

The answer: Not really. Most of the capital raised through the Fed’s emergency borrowing has landed on the large domestic banks’ balance sheets but has gone no farther. Without the multiplier effect of those newly printed dollars changing hands throughout our financial system, we will not really feel the brunt of the dollar’s supply and demand imbalance that I alluded to above.

The Fed created the Quantitative Easing programs as a means of providing insurance against an even greater collapse of our economic system. They provided the liquidity to the banks to ensure that if it was truly necessary, the banks had the capital to keep the economy from a complete failure. So far, that capital has gone largely unused as the economy appears to be largely headed on the right track with methodical growth in GDP, employment, and capital expenditures. All of which has taken place without much of the emergency capital ever making its way off of those domestic banks’ balance sheets.

The Fed is now tasked with playing a watchdog role. They must diligently monitor the ebb and flow of liquidity in our credit markets. If it appears that the capital is beginning to flow from the banks to corporations and consumers, the Fed will have to act quickly to step in and slow the velocity of money. This will be done in order to stem wild price increases due to the release of the pent up capital into the general economy.

The Fed giveth, the Fed taketh away.

Just as Chairman Bernanke and the Fed acted quickly to provide the capital to our banks to stem the fears of their insolvency and calm the general public, the Fed has the ability to unwind those liquidity measures to pull that capital back out of the economy. There are three actions that define the Fed’s exit from its extraordinarily accommodative policy: draining bank reserves to move away from today’s super-abundant level, raising the policy rate to withdraw the extraordinary degree of monetary accommodation today, and shrinking its balance sheet which, during the crisis period, more than doubled in size.

Chairman Bernanke has presented an outline of the likely exit strategy, including the tools to be used, and the sequence in which the three steps could be taken: first, start to drain reserves, next, raise the policy rate (but not much later than the beginning of the reserve draining), and still later, if at all necessary, sell MBS to shrink its balance sheet.

Can the unwinding efforts be carried out without unwanted inflationary effects?

The simple answer is yes, however there is no guarantee that this transition will be a seamless one so be prepared. The Fed will likely air on the side of caution (choosing inflation over steps that may cause deflation) which means bond yields will go higher and your purchasing power may continue to face downward pressure.  Does that signal an end to the US Dollar’s prominence in the global economy? I’d say not today, not tomorrow, and not for the foreseeable future but investors and consumers alike should heed this warning and take steps to protect their purchasing power and therefore, their long-term independence.

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