The Federal Reserve is a famously inscrutable institution. Given their ability to move markets, Fed officials have long been in the habit of speaking in careful, jargon-laced language that is often constructed with the express purpose of saying not much at all. That’s why when the Fed does communicate with the public, market watchers scrutinize each phrase and clause in order to divine any changes in the central bank’s behavior. And following yesterday’s final Federal Open Market Committee meeting of 2012, there was a single phrase that got the economics world buzzing, and sent financial markets into a bipolar tizzy.
Ready for it? Instead of promising to keep short-term interest rates at near-zero until at least 2015, as it did in its last statement, it pledged to keep short-term interest rates near zero at least until the unemployment rate falls below 6.5% or projected inflation gets above 2.5%. If this change doesn’t sound earth shattering to you, allow me to explain.
The Federal Reserve has two main tools for stimulating the economy. One is through “open market operations,” or the buying and selling of government securities to affect interest rates. The Fed didn’t change much in this regard. It’s continuing to keep short-term interest rates near zero and attempting to drive down long-term interest rates by purchasing longer-term Treasury securities and mortgage-backed securities at roughly the same pace as the past several months.
The other powerful tool the Fed has is its ability to affect expectations of future interest rates. And this is the tool the Fed is leveraging with its recent policy change, and the one it’s been employing with greater intensity for more than a year now. It began in the summer of 2011 by promising that it would keep interest rates low until 2013. It doubled down on this strategy in January of this year by extending that date to 2014. Then, with the September 13th launch of third round of quantitative easing (aka QE3), the Fed promised that it would keep up a $40 billion monthly purchase of mortgage-backed securities “for a considerable time after the economic recovery strengthens.” And today’s announcement linked future policy to the unemployment rate, paired with a higher inflation target of 2.5%
The U.S. dollar could lose its status as a reserve currency used by countries worldwide for foreign reserves and to conduct commerce if Washington doesn’t make lasting fiscal reforms soon, said Michael Pento, founder of Pento Portfolio Strategies.
Washington needs to push through both short-term and long-term reforms to taxes and spending to keep the greenback attractive. In the more immediate future, lawmakers and the White House will be scrambling during the coming days to steer the economy away from the year-end fiscal cliff, a combination of tax hikes and deep spending cuts set to kick in at the same time and tip the country into a recession.
Today, the dollar and U.S. Treasury securities remain popular safe-haven investments thanks to the European debt crisis, which continues to drag on with relief here and there coming from temporary measures such as bailouts for countries like Greece.
Investors looking to cut their European exposure have flocked to U.S. government debt despite Standard & Poor’s decision to strip the United States of its coveted triple-A rating in 2011, when lawmakers raised the country’s debt ceiling at the last minute and narrowly avoided default.
Such a trend won’t last forever if Washington doesn’t put politics aside and make lasting fiscal reforms. Elsewhere, debt concerns in the United States make precious metals a wise investment, gold especially, as the yellow metal tends to trade inversely to the dollar.
“You are going to have a bond market crisis accompanied by a dollar crisis, so if the dollar is losing its value, there is no way you are going to be buying anything else besides precious metals,” he stated.
“You must own precious metals. They have thousands of years of history of maintaining their value during hyperinflation and intractable inflation, and that’s where we are headed eventually if we don’t get our fiscal house in order.”