On Wednesday, the Federal Reserve announced that it would begin purchasing $45 billion in long-term Treasury bonds each month going forward to expand the its balance sheet, and would continue to buy $40 billion in mortgage-backed securities each month to help the recovery of the housing market. That's $85 billion of securities purchases every month!
Given this effort on the part of the Fed, the projection is for interest rates to remain near zero as long as the jobless rate remains above 6.5 percent… and as long as inflation is no more than 2.5 percent for the next one to two years ahead, which is consistent with the current Federal Reserve staff projection.
Short-term interest rates are expected to remain near zero into 2015. The market response to this? The value of the dollar declined.
The value of the dollar relative to the euro closed at about $1.31, down one percent from last week, and down by almost 3 percent over the past month. The Wall Street Journal U.S. Dollar Index fell to a low of about 79.7 on Wednesday, down from almost 1 percent from the level it hit last week, and down not quite 2 percent from one month ago.
The players in the foreign exchange market are not shy about expressing their opinion concerning the monetary policy announced by the Federal Reserve on Wednesday. The immediate reaction to the Fed's policy announcement was that more credit inflation was on the way.
This reaction is consistent with the "bets" now being placed in the U.S. housing market. See my recent posts: "Is It Too Late To Get Into The Housing Rebound?" and "Is It The Too Late To Get Into The Housing Rebound: Part Two?" In the housing market, we see large commercial banks, hedge funds, and the financial wings of construction companies making large "bets" on the recovery in housing spurred by Federal Reserve largesse.
The problem being observed in the housing situation is one that we should take note of when looking at the performance of the general economy and the possibility of lowering unemployment to the 6.5 percent range.
The housing market is improving, and the players -- the large banks, the hedge funds, and the finance wings of construction companies -- are starting to make substantial profits in housing finance. Real activity, the construction of new homes, is also increasing, but only modestly.
In translating this into the performance of the economy, one has to ask a question about whether or not the Fed's action will eventually have much of a real effect on economic output, or will the monetary expansion just contribute to one form or another of additional credit inflation?
Economic agents have built up an experience of credit inflation over the past 50 years. As we have seen in the actual case of price inflation, once increased, price expectations are very, very difficult to bring down. The same with the prospects for credit inflation.
My concern is that people, especially sophisticated people like mega-bankers, hedge fund managers, and the owners of large construction firms, are very responsive to the possibility for further credit inflation. They have built up this sensitivity over the past 40 or 50 years. This is why we are observing their current participation in the housing sector.
Why should construction firms have substantial financial subsidiaries? Well, for the same reason that General Electric (GE) and General Motors (GM) built up large financial wings. In periods of credit inflation, finance produces more profits than does manufacturing… or constructing homes.
Furthermore, in macroeconomic theory, we used to argue that over time, monetary expansion had very little impact on "real" economic values. Over time, monetary expansion only impacted "nominal" values. I have not seen anything over the past few years to make me change my mind on this fact.
So, the Fed announced its latest proclamation, and the value of the dollar declined. Another place to look for a market response on this is the bond market. The difference between the Treasury bond yield for a given maturity and the bond yield on the inflation-adjusted Treasury of the same maturity is an estimate of the inflationary expectations of financial market participants.
Wednesday after the Fed's announcement came out, the spread between the yield on 10-year U.S. Treasury bonds and the yield on the 10-year Treasury inflation adjusted bonds rose. In my mind, this gives us another indication that financial market participants are very sensitive to what the Fed is doing and, at least, the initial interpretation of the current Fed's stance is that more credit inflation is on the way.
Over the past couple of years, the initial reaction to announcements of Federal Reserve easing was for the value of the dollar to decline. Of course, there have been a lot of other things going on, especially the financial crisis taking place in Europe. Right now, conditions in European financial markets are relatively benign. As a consequence, the initial reaction to the new Fed statement is for the value of the dollar to decline… against the euro… and against other major currencies.
The financial markets seem to believe that the recent positions taken by major banks, the hedge funds, and the financial wings of large construction companies are the correct ones. The financial markets seem to be saying that the current round of credit inflation will generate substantial profits for these financial institutions, even if there are only modest increases in the housing sector or in the real activity of the economy as a whole.