Monetary Cliff?

As the election is approaching, little attention seems to be getting paid to the question that may affect voters the most, and that is what will happen to "easy money" policy. The election may impact everything from mortgage costs to the cost of financing the US debt.

By Axel Merk & Yuan Fang
Posted Wednesday, 24 October 2012
GoldSeek

As the presidential election is rapidly approaching, little attention seems to be getting paid to the question that may affect voters the most: what will happen to the “easy money” policy? Federal Reserve (Fed) Chairman Bernanke’s current term will expire in January 2014 and Republican candidate Mitt Romney has vowed that if elected, he would replace Bernanke. Given the tremendous amount of money the Fed has “printed” and the commitment to keep interest rates low until mid-2015, the election may impact everything from mortgage costs to the cost of financing the U.S. debt. Trillions are at stake, as well as the fate of the U.S. dollar.

Should Obama be re-elected, Bernanke might continue to serve as Fed Chairman; other likely candidates include the Fed’s Vice Chairman Janet Yellen and Obama’s former economic advisor Christina Romer. With any of them, we expect the Fed policy to be continuingly dominated by the dovish camp, and moving – with varying enthusiasm depending on the pick of Fed Chair – towards a formal employment target, further diluting any inflation target. We are not only talking about Bernanke and the other two candidates’ individual policy stances (though all three are known as monetary “doves”, i.e. generally favoring more accommodative monetary policy), but also the composition of voting members of the Federal Open Market Committee (FOMC), as we will discuss below.

If Romney were to be elected, a front-runner for the Fed Chairman post is Glenn Hubbard, Dean of Columbia Business School and a top economic adviser to Romney. Hubbard has expressed his skepticism about the mechanism that Bernanke used to boost the economy. In our analysis, an FOMC led by Hubbard (or another Romney appointee) will be leaning toward mopping up the liquidity sooner. Extending forward guidance to mid-2015 will also be under question. It will no doubt add uncertainty to monetary policy and increase market volatility.

More importantly, however, a “hawkish” Fed Chair, i.e. one that favors monetary tightening, might put to the test Bernanke’s claim that he can raise rates in “15 minutes”. Technically, of course, the Fed can raise rates by paying interest on reserves held at the Fed or sell assets acquired during various rounds of quantitative easing. The challenge, no matter who the Fed Chair is going to be, is the impact any tightening might have on the economy. Bernanke has cautioned many times that rates should not be raised before the recovery is firmly “entrenched.” What he is referring to is that market forces may still warrant further de-leveraging. If the stimulus is removed too early, so Bernanke has argued, the economy might fall back into recession. A more hawkish Fed Chair, such as a Glenn Hubbard, may accept a recession as an acceptable cost to exit monetary largesse; however, because there is so much stimulus in the economy, just a little bit of tightening may well have an amplified effect in slowing down the economy. Keep in mind that European countries are complaining when their cost of borrowing rises to 4%, calling 7% unsustainable. Given that the U.S. budget deficit is higher than that of the Eurozone as a whole, and that our fiscal outlook is rather bleak, it remains to be seen just how much tightening the economy can bear. Our forecast is that with a Republican administration, we are likely to get a rather volatile interest rate environment, as any attempt to tighten may have to be reversed rather quickly. Fasten your seatbelts, as shockwaves may be expressed in the bond market and the “tranquility” investors have fled to by chasing U.S. bonds may well come to an end. Foreigners that have historically been large buyers of U.S. bonds may well reduce their appetite to finance U.S. debt, with potentially negative implications for the U.S. dollar.

Let’s dig a little deeper and look at who actually decides on interest rates: it is the voting members of the FOMC that ultimately make the imminent monetary policy decisions, rather than the noise creating pundits and non-voting members.

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