Wednesday, May 27, 2009

By Ashish Advani The Fed has a serious problem right now.

According to Glenn Rudebusch, senior vice president at the San Francisco Fed, the Federal Reserve would have to slash the Fed funds rate to a negative 5% by the end of 2009 to create the level of monetary stimulus implied by the Fed’s own economic forecasts.

Rudebusch said the U.S. recession is so severe that the sharp increase in the Fed’s balance sheet that started in late 2008 and the lower interest rates will only be reversed slowly. But he played down worries that more than doubling the balance sheet to more than US$2 trillion would lead to much higher inflation, or that a reversal would be tricky.

“The Fed’s short-term loans can be unwound quickly, and its portfolio of securities can be readily sold into the open market, so there should be ample time to normalize monetary policy when needed.”

What worries me is how the Fed will time the reversal of its current policies. When was the last time the Fed moved in time to either raise or drop rates? So why would I believe that this time they will get the timing right?

That’s why I’m concerned the Fed will mess up once again and keep rates at near zero for too long. This will mean significant inflation once we see the current fears of an uncontrolled slowdown disappear.

As soon as this fear is done, we will see galloping inflation.

The U.S. dollar has already started trading downwards at this point and we are still months away from inflation raising its ugly head.

The best currencies to hold during such turbulent times will be countries that have a balanced approach and which have not imbibed the ‘quantitative easing‘ kool-aid or have done very little to tide over the troubled waters. These currencies would be Norwegian Krone, Brazilian Real and the Indian Rupee to name a few.

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