The Fed & Unintended Consequences

The Fed, Commodity Prices & Economic Recovery

Twelve hundred miles (give or take) from Wall Street, me thinks that a not-so virtuous cycle has emerged regarding the government's various and sundry efforts to nurse the economy back to health.

The dynamic goes something like this:

Step 1: the Federal Reserve and Treasury essentially borrow and/or create money -- at this point, trillions of it -- then direct it where they think it's most needed (not necessarily to me or you . . . but that's another post).

Step 2: the markets ("Mr. Market") take note of all that deficit spending, and drive down the dollar while pushing up commodity prices.

Step 3: elevated commodity prices retard recovery.

To take just one example, at $80 a barrel, oil is likely twice what supply and demand would otherwise dictate at the moment. Meanwhile, "stores of value" like gold -- now around $1,100 an ounce -- drain money that would otherwise fund economic growth.

Step 4: the Federal Reserve and Treasury, noting anemic growth, serve up another helping of stimulus cum deficit spending (see Step 1).

How long can this go on?

As many commentators have now noted, eventually one of two things happen: 1) economic recovery kicks in, and the government can taper its rescue efforts; or 2) the U.S. bumps up against the natural limits of its ability to borrow (not a bright line).

The "canary in the coal mine" for this kind of kind of fiscal/monetary tightrope is Japan, which is a good 15 years ahead of the U.S. on its trajectory of boom, bust, and (non)recovery.

The lesson for policymakers would seem to be, "don't do what Japan has done."