If the Fed Won't Defend the Dollar, Who Will?

Pimco's Bill Gross was on CNBC last Thursday suggesting the Federal Reserve should be injecting money into the system to alleviate current problems in housing and the financial space by lowering the fed-funds rate to roughly 3 1/2 percent. Other highly respected commentators, such as former Federal Reserve Governor Wayne Angell have made similar public statements, which should remind us of both the short and long term history of how we got here.

Notably, the dollar has been weak for years, and that ought to lead us to consider what the federal government used to do to prevent currency weakness before the Federal Reserve took over. As the dollar fell, the Treasury or the U. S. Federal Reserve was supposed to bid for it as a way to maintain its legislated value in terms of gold. In practice, the banking system kept the system balanced through arbitrage between London and New York. Back in 1930 the dollar/gold price was $20.67 an ounce, and it’s probably $450 - $475 for a ten-year moving average today. In any case, the dollar is trading at $867 an ounce as this is written.

With the dollar weak these past several years, and with real estate possessing a tendency to move like other dollar-denominated commodities, most people who rode the recent real-estate boom found it easy to refinance their homes given their commodity-like strength. Rates were falling at the same time, which made the process much easier than normal, especially true with “teaser rates” available as a competitive device for the initial term of the mortgages. At the point they were due to rise, the property owner simply refinanced the home thanks to rising real estate prices. Unfortunately, as the dollar continued to fall, various credit instruments tied to property became less marketable. For example, Citicorp suddenly found it could not find a bid or even place a value on a large portion of its portfolio.

We are now at the point where something should be done about this (a timeless statement), and the Fed would have an easy job, were it able to see it. With a falling dollar the problem, Chairman Bernanke could authorize a simple buyback plan for a portion of the Fed's outstanding Federal Reserve notes. Corporations do this all the time, and institutional investors cheer when companies repurchase their own stock.

The Fed and many “modern” economic commentators no longer realize that propping up their money will solve “the dollar problem” of inflation. They are preoccupied with running the economy through interest rate targeting: high means stop, low means go. At least, I think that is the translation. Simply put, rather than seek to maintain a stable dollar, the Fed guesses on a proper rate target in hopes of achieving stable, non-inflationary economic growth.

A better, more time-tested answer would be for the Fed to support the dollar at some predetermined level, which used to be the gold price chosen by Congress. This is admittedly tricky today absent an old-fashioned reference point, but it is essential for the monetary authorities to realize they must buy their own currency when they believe it has sold below the correct number, or, in other words, when it has weakened too much.

Think about it: if the Fed, the monopoly supplier and therefore ultimate dollar insider, isn’t going to buy dollars when they are cheap, who will?