Liam Halligan: Fed's foolhardiness is more worrisome than deflation

By Liam Halligan
The Telegraph, London
Saturday, December 20, 2008

http://www.telegraph.co.uk/finance/c...

During the second half of 2008, the most important global currency trend has been the strength of the dollar. It's not that the US economy has been strong -- far from it. The greenback, instead, has been a "safe haven."

Since the credit crunch tightened over the summer -- and particularly since the mid-September collapse of Lehman Brothers -- the name of the game has been "refuge." Across the world, traders have dumped risky equities and moved into bonds -- in particular, US Treasuries.

Emerging markets have suffered too, despite often having stronger growth prospects than Western economies -- as US and other dollar-denominated investors have sold anything exotic and brought money back home.

Such deleveraging and repatriation trades have driven the dollar rally. But that game may now be up. On a trade-weighted basis, the US currency has fallen 11pc in just three weeks. In the last week alone, the euro has risen 8 percent against the dollar -- the largest increase since the single currency's inception in 1999.

Over the last fortnight, gold has also surged 20 percent. So are currency dealers now seeking refuge from their refuge? Could the US currency collapse?

The dollar has lurched because, in recent weeks, the US Federal Reserve has lowered the Fed Funds interest rate from 2 percent to 1 percent. And then on Tuesday, of course, the rate was slashed yet again -- to virtually zero.

The gap between euro and dollar base rates is now 2.5 percent -- putting massive pressure on the US currency. And short-term US rates are now below Japan's for the first time since 1993.

Any fundamental view of the dollar, though, depends on one's opinion of the Fed's strategy. Will the "zero interest rate policy" help the US economy recover? Or will it make matters worse?

I ascribe to the latter view. And I fear an outright collapse in the dollar -- and the havoc that would bring to the already traumatised global equity and debt markets -- may not be far away.

The Fed -- along with almost every mainstream Western commentator -- argues rates must be slashed to tackle deflationary dangers. The spectre of deflation looms large over every decision the US authorities now make.

But to my mind, America's problem isn't downward but upward price pressures. US government borrowing has spiked -- up from an annualised rate of $310 billion in the second quarter of this year to an astonishing $2,000 billion now.

America's monetary base -- notes and coins in circulation -- has also grown at an unprecedented pace, up from $820 billion to $1,130 billion in just a few months.

Both US fiscal and monetary policy are now wildly expansionary -- to an extent never seen before. And the authorities aren't stopping there. Obama's presidency will spark a vast wave of government spending, financed by debt.

Under the euphemism of "quantitative easing," the Fed will also keep printing billions and billions of dollars, using them to buy up mortgage debt, credit card debt, and other dodgy securities the private sector doesn't want.

The danger isn't deflation but a surge of Weimar Republic-style inflation. The US authorities aren't lubricating the system, as they claim. They're flooding -– drowning -- their economy with cash. And they'll carry on doing so -- pandering to Wall Street -- until something forces them to stop.

That something could be the dollar -- and even a US gilts strike. The yield on the 30-year US bond is now 2.6 percent -- the lowest for 50 years. Traders aren't buying those bonds because they think it's a good deal to collect 2.6 percent on their money each year. They're buying them because, under intense pressure from bosses and regulators to "go safe," they're scared for their jobs.

Such forced buying and related low yields suggest the US Treasuries market is now a bubble. And bubbles always burst. The Fed is committed to buying long-term US government debt itself in huge quantities. But as America's liabilities rise and the printing presses keep rolling, the dollar must surely keep falling. And as it does, the argument for holding US Treasuries collapses.

The danger looms that, pretty soon, the only net buyer of US Treasuries could be the Fed itself. Very serious questions would then be asked about America's ability to service its debt. Foreign creditors could start calling in the money they're owed by the States.

This scenario is alarming, but far from impossible. And the reason the world is flirting with this danger is because the Fed needs to fight deflation.

But the Fed's argument doesn't stack up. US inflation -- as measured by the pre-Clinton methodology, before the politicians started messing with the numbers -- stands at 4.5 percent.

Deflation is being used as an excuse for the US authorities to print money like crazy, attempting to bury their mistakes and bail out their Wall Street friends.

This reality is crystal-clear. The fact other economists aren't shouting it from the roof tops is both an outrage and a farce.