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No Free Lunch: Ongoing Ramifications of an Easy Fed

Tuesday, October 23, 2007 | 06:43 AM

in Commodities | Currency | Federal Reserve | Inflation | Taxes and Policy

I had lunch with Richard Clarida a few years ago after meeting him at CNBC. He is a very nice guy, a Columbia economics professor, a former assistant U.S. Treasury secretary for economic policy, and is now a global strategic advisor at PIMCO.

He was actually introduced to me as "one of the few people who managed to escape from the White House with his reputation intact."

The professor has a very intriguing WSJ Op-Ed today, titled "The Dollar's Got Further to Slide." My alternative title would be easy No Free Lunch: Ongoing Ramifications of an Easy Fed.

Richard argues, somewhat incidentally, that the dollar's slide, as well as its future prospects, must be consider in the context of Fed action over the past decade:

"As the nearby chart shows, since 2001 there have three distinct phases of what I have called the dollar downdraft. From 2001 though the spring of 2004, there was a trend decline in the dollar against the currencies of other major countries. This occurred during an initially sluggish U.S. recovery and an aggressive ease in Fed policy that drove the fed funds rate down to 1% and kept it there for a considerable period.

In 2004, as the U.S. expansion was robust, productivity growth remained strong, and the Fed began hiking interest rates to normalize policy "at a measured pace," the dollar downdraft was put on hold. During this period from June 2004 (the first Fed hike) to August of 2006 (the first Fed pause), the dollar was in a trading range, neither trending up nor down, a fact that surprised a market consensus going into 2005 that a dollar fall for that year was inevitable . . .

Since the August 2006 meeting, at which the Fed announced at least a pause if not an end to the interest-rate hike cycle, the dollar downdraft has resumed. There are several reasons for this, and these reasons suggest the dollar downdraft is likely to continue for some time to come. First, the U.S. economy in the second half of 2006 slipped into what has now been more than a year of below-trend growth. Moreover, this occurred in the context of buoyant global growth, not only in the developing world, but also in Europe, Canada and Asia.

This relative U.S. underperformance is likely to continue, as the economy works through the headwinds of the housing contraction and consumer retrenchment in the face of tighter credit conditions and a soft labor market. But a U.S. recession is not necessarily in the cards, in large part because the Fed will probably ease more in future months to provide insurance against an economic contraction.

In the rest of the piece, the professor argues that the US is likely to avoid a recession, as the Fed stands ready to cut more aggressively if need be. If and when that happens, we should expect more dollar weakness.

One of the corollaries to this is that any Fed action has genuine, long lasting consequences. When rates are held at very low levels for long periods of time, as we saw from 2003-04, there are serious consequences. When the Fed is tightening, there are also major ramifications.

However, the cost for economic stimulus is inflation, and as we have seen during this past cycle, a weak US currency.

However, those pundits who have begged for rates failed to consider: there is no free lunch. Its the first rule of economics, and the cost of this stimulus is elevated prices, and ongoing inflation.

Source:
The Dollar's Got Further to Slide
RICHARD CLARIDA
WSJ, October 23, 2007; Page A19
http://online.wsj.com/article/SB119310280353567921.html