The Federal Reserve System’s insistence upon managing domestic interest rates puts it yet again on the horns of a dilemma: save economic growth and trash the dollar, or save the dollar and trash economic growth? Either alternative is a losing proposition. This is yet another demonstration that Keynesian mercantilism provides no good outcomes, except to its circle of intended beneficiaries.

Abnormal Credit Conditions

Solely due to Fed mismanagement of monetary policy, the yield curve of domestic interest rates inverted 18 months ago. In other words, overnight funds for banking reserves became more expensive than yields on Treasury securities at any maturity date. This inversion is abnormal in all market conditions, and has caused strains and dislocations in credit relations throughout the year-and-a-half of its existence. Anyone borrowing at the short end of the yield curve, such as small businesses and consumer credit card users, has paid double-digit interest rates or been denied credit altogether from the beginning of the inversion.

As 2007 began, the Fed stopped injecting new funds into the economy as had been done throughout the period of consecutive hikes in the funds rate, and actually drained funds on net for the first half of the year. Difficulties in funding commercial paper rollovers became apparent to the Fed in August, prompting emergency injection of $39 billion in temporary funds. However, despite the Fed’s increase in those temporary funds to about $47 billion in November, the relief initially apparent in credit markets reversed and, in the last week of November, commercial paper again dried up as a source of capital for businesses, even to the point of sucking up and collapsing debt already existing and financed by paper due for rollover.

Former Governor Angell’s Proposal

On November 29, these concerns persuaded former Fed governor Wayne Angell to urge on CNBC’s Kudlow & Co. that the FOMC should cut the funds rate by a full 1% (100 basis points), and should couple that action with a firm public commitment to strengthen and stabilize the dollar. Angell’s prognosis was immediately echoed by Arthur B. Laffer and praised by CNBC’s Steve Liesman, who effused that he had favored such actions for weeks.

Angell’s shift from previous opposition to a further cut in the funds rate at the December FOMC meeting is significant in two primary respects. It tacitly acknowledges that Fed funds rate management is at fault for the credit strains now imperiling economic growth. More importantly, it acknowledges that the Fed is capable of cutting the funds rate sharply while still acting to strengthen and stabilize the dollar. This implies that the funds rate is not the valve that controls liquidity or the strength of the dollar, a conclusion I have expressed previously.

Free the Dollar from the Funds Rate

The important further implication is that the Fed need not manage domestic interest rates to manage the dollar. The fact that the Fed insists upon manipulating the funds rate despite the damage caused indicates other unstated purposes for its conduct.

Even Angell’s proposed cut of 1 percent in the funds rate on December 11 is unlikely to relieve credit market strains produced by the inverted yield curve. The yield curve probably would remain partially inverted, as the funds rate would be higher than the market judges overnight funds are worth. The overnight funds rate ought to be allowed to “float” to the level assigned by market judgment so banks and other lenders can begin again to provide the credit demanded by economic growth.

So long as the Fed continues to state an overnight funds rate “target,” the Fed will remain behind and out-of-step with the yield curve, producing credit strains that the market cannot always overcome. The Fed ought to free the markets to set the funds rate, then promptly announce, as Wayne Angell proposes, that the Fed will focus on strengthening, then stabilizing, the dollar’s value. ~