The Fed’s Historic Announcement

Mark it down. At 2:15 p.m. on Tuesday, August 10, 2010, the U.S. Federal
Reserve made a historic announcement. It signaled that the central bank was
going to "preserve the size of its balance sheet." The announcement didn’t
sound all that dramatic, but don’t be fooled. In the two subsequent days, the
stock market fell over 300 points, and the price of gold rose $20.

The Fed’s balance sheet, which historically consisted of nearly 100 percent
U.S. Treasury securities, has grown in size from about $850 billion to a
towering $2.3 trillion (or $2,300 billion) currently. In the middle of the
financial crisis two years ago, the Fed expanded its holding of securities by
purchasing lower-quality, mortgage-backed debt securities primarily from our
nation’s domestic banking system. The need for this balance sheet expansion was
to provide massive liquidity for our entire financial system.

The cash used to purchase the debt securities was literally created out of thin
air, or in other words, the Fed simply printed the money. Two years ago, the
financial emergency was deemed severe enough to require this dramatic
money-printing exercise by the Fed. There was never any intent to make the vast
expansion of money injected into the banking system anything other than
"temporary" due to the financial emergency. There was always discussion in the
financial press and among Fed policy makers of an "exit strategy." The "exit
strategy" discussion implied that the inflationary (or even
"hyper-inflationary") potential of this massive expansion of the banking
system’s base reserves was being monitored closely. The financial markets took
comfort that the Fed was standing at the ready, to withdraw the cash, should
there be any sign that the central bank’s monetization exercise was having a
negative effect on investor inflation psychology. That feeling of comfort has
been dealt a blow with the Fed’s announcement on August 10. There is now no
"exit strategy" being considered, and the size of the central bank’s balance
sheet may very well become permanent.

Historically, the U.S. Federal Reserve has been given two primary objectives:
one is the preservation of the purchasing power of the U.S. Dollar, and the
other is to conduct a monetary policy that supports full employment. It is not
an easy task to serve two masters. Additionally, in its role as a central bank,
the Fed is to remain an independent institution that resists political
influences. This, too, is not an easy task. The Fed’s track record as an
independent institution that has preserved the purchasing power of our currency
and maintained full employment is fully open to challenge. The central bank has
not always demonstrated a firm independence from political influence, and the
purchasing power of the U.S. Dollar has significantly diminished over the past
40 years.

An independent central bank, free of political influence, has always been a
critical corner stone supporting confidence in whatever the currency the bank
is charged with managing. Confidence is the one and only real currency of a
central bank. What has just transpired here with the Fed’s announcement is
that, in no uncertain terms, the central bank has explicitly stated it is
prepared to "preserve the size of its balance sheet." And I would add, what it
didn’t say explicitly, but did signal to the political class in Washington, is
a willingness to "further expand the balance sheet dramatically if need be."
The fancy term being used to describe its intent here is called "quantitative
easing" or "QE."

The real inflationary (or hyperinflationary) risk that the financial markets
will calculate very carefully going forward is that the central bank, with this
announcement, has now opened itself to being fully co-opted by the political
process in Washington. Consider, why make hard political decisions on taxes and
spending when the central bank has, in effect, just announced that it stands at
the ready to print the money to finance any deficit of any size in order to
underwrite any amount of future debt accumulation?

The political class in Washington will see the Fed’s announcement as a
potential gold mine. They will no doubt attempt to mine it for all it’s worth.
The significantly rising risk is that the accumulation of future government
debt attended to this process will result in hyperinflation rather than a
garden-variety, modest inflation.

Hyperinflation occurs when there is a total collapse of confidence in a
currency. A central bank that is willing to simply print money out of thin air
to finance unlimited amounts of debt will eventually undermine the confidence
in the currency being managed as lenders eventually seize on the realization
that they will never be paid back in anything other than worthless paper.

The road to hell is indeed paved with good intentions.

— Fred A. Kingery is a self-employed, private-equity investor in domestic and
international financial markets from New Wilmington, Pa., and a guest
commentator for [2]The Center for Vision & Values at Grove City College.