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Is the Federal Reserve Doing a Good Job?

March 25, 2012 | About:

The U.S. Federal Reserve is taking a different approach to the American economy than it has in the past. Due to outcry from from many who have questioned the Fed's very existence, Fed Chairman Ben Bernanke is communicating more directly and openly -- kind of -- with the public and offering more detailed explanations regarding forecasts.

However, many people suspect that the Federal Reserve and the BLS both understate inflation and that the new data regarding the economy is contradictory.

Many would say that to date, American monetary policy has not been effective. They argue that policy alone cannot erase huge federal debt, excessive regulation and taxes, and seemingly unending deficit spending by the U.S. government. Under pressure to take action, the Fed has purchased more bonds and maintained a near-zero interest rate. The economy seesaws in response to each piece of news -- a price we pay for essentially having a quasi-centrally-planned monetary market.

Some experts -- including several writers here at Guru Focus -- believe that uneven economic statistics will lead the Fed to offer the quantitative easing so many are anticipating, especially if there is so much as a hint at a double dip recession.

As gas and oil prices rise, economic activity slows. Many bank economists have reduced their first quarter 2012 GDP estimates from three to 1.7 percent.

Charles Evans, Chicago Fed president, requested additional action from the Fed last Friday to “accelerate the pace of recovery.” I think we know what that means.

China and the European Union are engaging in quantitative easing. As the Fed is pressured to purchase more bonds, market volatility will increase and lead to additional quantitative easing. This economic relief weakens the dollar but increases gold prices, at least compared to what they would be with less Fed action.

A weak dollar means (everything else equal) more currency is required to purchase one ounce of gold, which increases the dollar price of the precious metal.

People have stored wealth in this metal for centuries to avoid negative effects of declining currency values and maintain their financial worth.

During the last three years, the Fed has provided banks with more than $2.3 trillion. It also loaned over $16 trillion to these financial institutions. The idea was that the additional liquidity provided during a deflationary period of the recession would stimulate the economy. Banks would be able to lend more, providing more spending money to consumers and more financing for businesses to grow to meet this heightened demand. The hope was that the recession would lead to expansion and prosperity, with side benefits of increasing wages, low unemployment rates, and strong growth in GDP.

The problem, of course, has been the thing called a "liquidity trap". Lots of money exists in balance sheets but has no where to go -- this was extremely profound at different points in 2011, when banks literally were having more money deposited than they wanted.

The concept that an increase in the money supply causes demand which increases economic movement is not new. John Maynard Keynes introduced the idea in 1936. He believed that the business cycle could be stabilized more effectively by the government than the private sector. Under his economic model, government fiscal policy and central bank monetary policy exert control. This model was used during the tail end of the Great Depression as well as during World War II and the period of economic expansion following the war.

Keynes believed that spending should increase during a recession, and then fall back during more prosperous times. Of course, the theory and the application of the theory always have problems. The Austrian school has done a stand-up job of responding to his view with an alternative understanding of the business cycle, especially in the context of artificially cheap credit and low interest rates.

Since the 2007 financial crisis, the UK, U.S., and a large portion of the European Union have used Keynesian-based stimulus efforts. In each case, this quantitative easing has negatively affected the currency. The result of another round of quantitative easing should be no different. Many people are reminded of the economy of the 1970s and current Fed policies are similar to those of that era. High inflation and high unemployment aren't opposites -- as many people struggling to find work or pay for food are now realizing.

Today, a dollar purchases at least 17 percent less than it did in 2009 following a round of money printing. As the dollar continues to be debased, many people are migrating from dollar denominated asset investments into commodities like gold. Since 2009, the price of gold has doubled. Whether it'll keep increasing depends on plenty of different factors that I'll be discussing in a new article soon.

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