Behind the Fed's Policy Leak

A front-page WSJ story, “Fed Mulls Symbolic Shift,” is a great leak from the central bank to reporter Jon Hilsenrath. Basically, the Fed wants to stop its $2.3 trillion balance-sheet portfolio from shrinking and therefore tightening monetary policy. So, when its mortgage-bond holdings mature, the Fed would take the principal and interest and go into the open market to replace the bonds. This would keep the Fed’s holdings flat, or stable, rather than have the holdings run off.

Inflation-sensitive markets did very little on the news yesterday. Gold was up slightly to $1,189, and the trade-weighted dollar continued its recent drop by about half a percent to 80.6.

What’s really behind the Fed move -- if the central bank announces it at its mid-month FOMC meeting -- is fear of an economic slowdown. The Fed doesn’t want to be seen as tightening its policy. The target rate is near zero already. But the balance sheet is the key to money creation.

Noteworthy is the fact that the monetary base has been flat-lined at $2 trillion for about 10 months, going back to last October. In sound-money terms, it would be okay with me if the Fed held the monetary base steady for a long, long time. That would keep the dollar stable and would probably keep gold prices steady. If investors actually believed in a stable policy, perhaps the greenback would rise while gold fell.

But alas, Bernanke is still engaged in economic fine-tuning rather than dollar value. We have no exchange-rate policy. Nor is there a gold policy. So no one could possible know where these prices are going.

Thinking back to Robert Mundell’s original idea years ago, an optimal policy would include low marginal tax rates and a steady dollar backed by gold. But marginal tax rates may go up, the dollar is not backed by gold, and the fate of the greenback is anyone’s guess.

Meanwhile, buying more bonds to create new cash for the economy is futile. There’s already $1 trillion of excess bank reserves on deposit at the Fed. In other words, the financial system has more dollars than it knows what to do with.

The economic recovery and job creation are being held back by tax and regulatory obstacles, not by a shortage of money. It’s fiscal policy that is wrongheaded. But then again, without a strong-dollar policy, no one can really give the Fed any kudus either.