No Free Lunch: Ongoing Ramifications of an Easy Fed

I had lunch with Richard Clarida a few years ago after meeting him at CNBC. He is a very nice guy, a Columbia economics professor, a former assistant U.S. Treasury secretary for economic policy, and is now a global strategic advisor at PIMCO.

He was actually introduced to me as "one of the few people who managed to escape from the White House with his reputation intact."

The professor has a very intriguing WSJ Op-Ed today, titled "The Dollar’s Got Further to Slide." My alternative title would be easy No Free Lunch: Ongoing Ramifications of an Easy Fed.

Richard argues, somewhat incidentally, that the dollar’s slide, as well as its future
prospects, must be consider in the context of
Fed action over the past decade:

Clarid_20071022195644"As the nearby chart shows, since 2001 there have three
distinct phases of what I have called the dollar downdraft. From 2001
though the spring of 2004, there was a trend decline in the dollar
against the currencies of other major countries. This occurred during
an initially sluggish U.S. recovery and an aggressive ease in Fed
policy that drove the fed funds rate down to 1% and kept it there for a
considerable period.

In 2004, as the U.S. expansion was robust,
productivity growth remained strong, and the Fed began hiking interest
rates to normalize policy "at a measured pace," the dollar downdraft
was put on hold. During this period from June 2004 (the first Fed hike)
to August of 2006 (the first Fed pause), the dollar was in a trading
range, neither trending up nor down, a fact that surprised a market
consensus going into 2005 that a dollar fall for that year was
inevitable . . .

Since the
August 2006 meeting, at which the Fed announced at least a pause if not
an end to the interest-rate hike cycle, the dollar downdraft has
resumed. There are several reasons for this, and these reasons suggest
the dollar downdraft is likely to continue for some time to come.
First, the U.S. economy in the second half of 2006 slipped into what
has now been more than a year of below-trend growth. Moreover, this
occurred in the context of buoyant global growth, not only in the
developing world, but also in Europe, Canada and Asia.

This relative U.S. underperformance is likely to
continue, as the economy works through the headwinds of the housing
contraction and consumer retrenchment in the face of tighter credit
conditions and a soft labor market. But a U.S. recession is not
necessarily in the cards, in large part because the Fed will probably
ease more in future months to provide insurance against an economic

In the rest of the piece, the professor argues that the US is likely to avoid a recession, as the  Fed stands ready to cut more aggressively if need be. If and when that happens, we should expect more dollar weakness.

One of the corollaries to this is that any Fed action has genuine, long lasting consequences. When rates are held at very low levels for long periods of time, as we saw from 2003-04, there are serious consequences. When the Fed is tightening, there are also major ramifications.   

However, the cost for economic stimulus is inflation, and as we have seen during this past cycle, a weak US currency.

However, those pundits who have begged for rates failed to consider: there is no free lunch. Its the first rule of economics, and the cost of this stimulus is elevated prices, and ongoing inflation.


The Dollar’s Got Further to Slide
WSJ, October 23, 2007; Page A19

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What's been said:

Discussions found on the web:
  1. Justin commented on Oct 23

    What I think the pundit seems to miss is that it is “too late.” We are already in a recession. 1974, here we come again!

  2. winjr commented on Oct 23

    “But a U.S. recession is not necessarily in the cards, in large part because the Fed will probably ease more in future months to provide insurance against an economic contraction.”

    Since when does the Fed determine whether or not the U.S. avoids recession?

  3. Philippe commented on Oct 23

    The best illustration of the US economy policy dilemma is provided by the works of Robert Mundell dividing the economy in four quadrangles considering the inter relationships between savings supply and demand of money, balance of payment, employment and interest rates (Yes all of these!)
    In a nutshell as long as the US economy is remaining with full employment, low investment and savings and low interest rates there is hope as soon as it drifts towards unemployment and the same characteristics, it is no longer hopes it falls in the field of fiscal, monetary, exchange rates inspiration.
    This is why the present Fed policies are sometimes abscond when it comes to balance the micro economic mess and the macro economic disaster.

  4. DD commented on Oct 23

    No one seems to consider the coming fiscal crises as a reason for at least part of the dollar slide. I think if Fiscal issues were at least being addressed in some reasonable manner you would see some dollar strength. But that doesnt fall into the category of “Print, Print, Print. Spend, Spend, Spend.”

  5. Costa commented on Oct 23

    I have a question how does the falling dollar effect companys outsourcing various jobs?

  6. kharris commented on Oct 23

    “…those pundits who have begged for rates failed to consider: there is no free lunch.”

    So, it’s back to the strawmen, is it? If your argument is not strong enough to stand without accusing people who disagree with you of being idiots, then it isn’t much of an argument. Here’s the homework assignment. Go and find calls for an ease that explicitly claim there is no risk of inflation. If you can’t do that, you are simply claiming there is a “free lunch” pundit class out there without any evidence.

    Most people who have paid any attention at all realize that monetary policy is always a trade-off. There are disagreemnts about the extent of the trade-off. Some people are less concerned about inflation than others. Who are these people that see no trade-off?

  7. UrbanDigs commented on Oct 23

    Well if the gov’t continues to use core #’s as their inflation measures for policy targeting, we may not have to worry about inflation as a result of fed easing to stave off or put a floor to any recession.

    After all, the fed says inflation is within their parameters right now. I dont see it, but hey, Im a real person and the gov’t never lies right!

    All I see is:

    1. rising living costs
    2. rising credit costs
    3. rising food prices
    4. rising gas prices
    5. rising heating oil prices
    6. rising electricity rates
    7. rising health costs
    8. rising school costs
    9. rising transportation costs

    To be fair, I do see..

    1. declining flat panel tv prices
    2. declining used car prices
    3. declining consumer electronics

    So I guess the things that are declining will offset the things that are rising. After all, who cant live without a flat screen tv these days!

  8. S commented on Oct 23

    Why would fed govs being talking about cataclysmic drops in home prices and protecting at all costs: read we don’t care about inflation or your savings.

    Kharris: Correct, economics is a social science right up to the point it tiptoes over the line and becomes a matter of finance

    The “braintrust” in DC is betting a combined game of chicken and horiozon pushing causes a renewed case of cognitive dissonance. That you could have a fed official essentially claim that a spike in the headline number to be followed by easier comps has no impact is astounding? I guess when Argentina devalues it doesn;t matter becasue people just adkjust to halving their savings halved.

    Long short or indifferent, the throttling of free markets by a somplicit fed is sad bordering on the criminal.

  9. Fullcarry commented on Oct 23


    If you paid any attention to CNBC you would know the number of people who believe in a free lunch is legion.

  10. Gary commented on Oct 23

    It seems pretty obvious that the Fed has entered another cutting cycle. Just like the first cycle precious metals will benefit. The precious metals have lagged energy and base metals during the first phase of the commodity bull. I expect they will outperform during the second phase as liquidity flows into undervalued assets.

  11. Groty commented on Oct 23

    CNBC’s Chief Free Market Cheerleader, Larry Kudlow, whose tagline is “free market capitalism is the best path to prosperity” is publicly calling for Treasury department intervention in the ForEx market to support the dollar.

    So, in the past 2-3 months, CNBC’s loudest proponent of free markets has called for both the FED and the Treasury to intervene in free markets.

    Not only is he an obvious hypocrit, but it’s an insult to his audience that he thinks they are too stupid to see through his facade of pretending to be a laissez-faire free market capitalist.

  12. zao commented on Oct 23

    Gary, I agree with you. A rate cutting cycle looks very probable. More evidence of their asymmetric policy follows.

    Evans Says Fed Must Guard Against ‘Cost’ of Bigger Housing Drop

    Oct. 23 (Bloomberg) — Federal Reserve Bank of Chicago President Charles L. Evans said policy makers must shield the economy from “high cost” events such a worsening housing slump.

  13. bj commented on Oct 23

    It seems the only way out of our mess is inflation and the debasement of our currency. Yet, this is knowledge that is simple and easily known. The real question I have is just this. How can a middle-income American who does not understand high tech finance invest in such a way to counter this destruction of currency and increase in prices? If this is a very long term trend that is inescapable, what can we do?

  14. NC Jim commented on Oct 23

    The USD has been sliding except for 2005 and I seem to recall a tax holiday that year for foreign corporate earnings brought back to the US supposedly for “investment”. If you eyeball the chart, the gain in 2005 almost exactly matches the calendar year. I cannot quantify the effect however.

  15. Justin commented on Oct 23

    I was just in high school back in the 70’s, so I had to go back and look what actually happened. It appears that it was the easy FED policy of Arthur Burns in 70, that lead to high inflation, and then Nixon, put the old price controls on. Question is: what is this group going to do? Cut rates even more? In my estimation the only logical step would be to raise rates like Paul Volker ended up doing; say in about 18 to 30 months from now. Like somebody said prior gold is where its at!

  16. Gary commented on Oct 23

    The easist way is to invest in gold and silver. I have posted many times on the
    my thoughts on the Fed’s inflationary bias.

  17. Norman commented on Oct 23

    I’ll bet against the professor and against the euro (the yuan is another matter). Get green with the greenback, I say.

  18. moodmovesmarkets commented on Oct 23

    I stopped at “bold–but appropriate–50 basis point cuts”. All I needed to read.

  19. bj commented on Oct 23

    Thanks for your replies. I think a glitch has my previous post under zao’s name and I will bet mine(bj) for his post. Anyway, I asked about what one could do. I have another question. Would index funds, in time, at least, track inflation upward? Would stock prices generally increase close to the rate of inflation. I know most want to make real gains by investing, but it is something just to keep in pace with inflation. If, in the coming years, inflation and currency debasement is coming, then there will be real pain in the lives of regular folks because, they (we) are losing purchasing power to inflation. Just keeping up with inflation is better than falling behind. But, most regular folks are going to need something simple to do. I don’t know if most can actually bring themselves to buy metals. But, would stocks in general keep up with inflation. If so, an index fund would have value. Just asking.

  20. bj commented on Oct 23

    Please disregard my comment about zao and my comments getting switched. I interpreted the designations of posters incorrectly. But, again, thanks for this blog and the postings.


  21. zao commented on Oct 23

    I agree with you. The Fed considers a falling dollar the least painful way for us to resolve our savings-consumption shortfall. This works only to a point. Then the foreign investors pull out and local interest rates will rise and asset mkts fall. Remember what happened in Asia in 97-98. I am not saying we are going to implode. Just a question of degree.

  22. Peter Pan commented on Oct 23

    Is it just me or is everyone and their mothers bearish on the $USD? Looking at a chart of the $USD (DXY) it appears that the $USD is staring into the abyss. I certainly can’t exclude the possibility that the $USD could crash or dislocate from this precipice.

    However, if the growth in the issuance of credit is the primary source of asset and price inflation, and if that credit is primarily valued in the $JPY and $USD (plus pegged currencies to $USD), then wouldn’t a contraction of credit issuance have a strengthening effect upon the $JPY and $USD since there would be fewer $JPY and $USD credits outstanding (i.e., less supply or inventory or circulation).

    If the USA is leading the rest of the world in an economic slowdown and there is no global decoupling, as Stephen Roach argues, then other countries will face a similar economic situation for which their currencies will have no real advantage relative to the $USD.

    Furthermore, if the $USD economy slows down, then imports into the USA should fall, which would significantly improve the existing trade imbalance. The improvement in the trade imbalance should also have the effect of strengthening the $USD.

    I suspect that if the credit contraction (and associated insolvency) are sufficiently severe, then the $USD and $JPY may even strengthen in a ZIRP environment. Of course, this is a very dismal and unpopular view.

    Peter Pan

  23. zao commented on Oct 23

    Peter Pan,
    your theory is not without merit. In fact, we saw a good example of this yesterday. Credit contraction worries leading to stock market falls and dollar rally and Yen rally against everyone else. However, I view this as the catastrophe scenario. The Fed is cutting rates and reflating precisely to offset the credit contraction implied by the bursting bubbles. If the Fed is winning, the dollar will fall. If the Fed loses, dollar should benefit as you point out. I will bet that the Fed will win the war between credit reflation war just as they did after the dot com burst.

  24. Al Czervik commented on Oct 23

    Funny. Almost everybody (including me) is long term bearish on the USD but almost everybody (including me) has also been expecting a counter-trend rally any day now, hoping for an opportunity to convert some more assets out of dollars at a better price. But the damn thing can’t even seem to get a decent bounce going. Thought the G7 meeting might provide an excuse. But so far, nothing. The greenback is really looking pathetic.

  25. BDG123 commented on Oct 23

    What is amazing to me is we selectively choose what we want to believe from economists yet they have never gotten economic forecasting correct. isn’t it ironic the top two economists on Wall Street over the past three decades have no formal training in economics? Many economists have something beneficial to say but they never get the future right. That means they are likely barking up the same tree. But, in an act of insanity we continue to look to them to once again get the future forecasts wrong.

    So, let me play devil’s advocate. Why didn’t long rates go up in the late 1990s when Greenspan tried to nudge them higher? And, more importantly, why did the Fed have to cut rates for two years to get the economy to respond in 2001-2003? I believe this bubble had little to do with Greenspan as the Fed has been tight for years. One year of artificially low rates did not cause a catastrophe of this size. And, the Fed has done nothing different than any other central banker has done throughout history. The EU policy has been just as loose. In fact, it has been more loose this cycle by many measurements. And, the EU central bankers dropped their drawers much lower than Bernanke with the unfolding situation we are seeing.

    What we are witnessing is not inflation. It is the deflation. It is the reduced spending power seen through the start of asset deflation that will become more apparent over time. It looks like inflation because that is what everyone is conditioned to look for in their biased thinking.

    No, this mess in the economy was not created by monetary policy any different than any other time in history. The future will unfold much differently than nearly anyone imagines and once again we will look back and see how everyone got it wrong.

    Just a counter position to consider……

  26. stormrunner commented on Oct 23

    >>Furthermore, if the $USD economy slows down, then imports into the USA should fall, which would significantly improve the existing trade imbalance.

    Though this is certainly a likely outcome, for j6p this would not seem beneficial. Our manufacturing infrastructure has been gutted as surely as if it were bombed. Almost everything that is unrelated to a service, now needs to be imported. Try to think of the last production item that you may have purchased that was made in America. After 30 years of decline at a substantial loss in many skills, Americans in order to cloth themselves, purchase appliances,consumables whatever, will need to rebuild this infrastructure or simply do without. When really all that was needed was to not allow unfair trade practices and keep still relevent technologies here. This is not protectionist its survivalist. Sanctions against our exports must be met with an equivilent sanction against the competing import especially in light of nationalized industry. We can’t compete therefore a sane person will not compete. The answer to a large multicultural nation such as the US is not solely education, and even if it were the cost of this education is pulling away from occupation compensation. We gave every thing away. At the consumer level other than for heavy appliances, refridgerators, washers, dryers etc. what is left. Without a hugh trade deficit even a substantial portion of the service sector related to the sales and service of such imports will be in decline, until the US living standard more closely matches the labor pools of the manufacturing economies. Not everyone can trade paper.

  27. Estragon commented on Oct 23

    I’ll toss in another contrary position. There are times when you CAN have a free lunch in the FFR/USD. In the early/mid 1980’s the FFR dropped a lot as the USD (major currency version) rose a lot. In the early/mid 90’s the FFR also dropped a lot while the USD range traded.

    One factor in both periods the fed was responding to a clearly weak economy with considerable slack and little inflation risk. Both periods were also the beginning of excellent US growth and innovation cycles.

    The late 80’s saw the USD fall a lot while rates came down a bit, but I’d argue that had as much to do with others (esp Japan) as the US. That said, the US did continue reducing rates even though there were few signs of slack.

    The takeaway is cutting rates when it’s clear there’s slack has been neutral to positive for the USD.

  28. Justin commented on Oct 23


    Are you not forgetting to include the Federal Deficit and its effect on the economy. The 80’s had our buddy Ronnie, spending like mad…ditto, George W. Bush this time around… The Neo-Classics got his daddy in big trouble by not dropping rates, etc… I think that’s the way it went. And now Greenspan, Bernanke, and team no only how to drop rates, and cut taxes. In my view we are rate-cutting, and tax-cutting our way into poverty.

  29. Estragon commented on Oct 23


    I’m not including lots of stuff from the 80’s, just looking at if/how the two factors (FFR/USD) in the posting were related. The post asserts a lower FFR = lower USD. A longer view of things suggests not always. As with tax cuts, timing is everything.

  30. FredS commented on Oct 23

    nice up day on the street of dreams today.
    bulls are smiling, bears are scratching their heads

  31. whipsaw commented on Oct 23

    I am pretty sure that a long $USD trade is going to work out well once we get past the next rate cut at the end of the month. USD has been beaten to death already and we are probably at the point that no other major US import partner can afford to let USD drop much more, so the sovereign banks will push it up.

    The manipulations may not matter in the long run, but for a trade I would say UUP is not a bad idea if you can close your eyes for a couple of months. I am going to wait until December when some CDs cashout, then I’ll put some cash into my FOREX account to deal with this, but there is probably some money to be made in the interim.


  32. whipsaw commented on Oct 23

    I am pretty sure that a long $USD trade is going to work out well once we get past the next rate cut at the end of the month. USD has been beaten to death already and we are probably at the point that no other major US import partner can afford to let USD drop much more, so the sovereign banks will push it up.

    The manipulations may not matter in the long run, but for a trade I would say UUP is not a bad idea if you can close your eyes for a couple of months. I am going to wait until December when some CDs cashout, then I’ll put some cash into my FOREX account to deal with this, but there is probably some money to be made in the interim.


  33. Juan commented on Oct 23


    You are correct. Without going to the data, I believe the last actual – and short – period of deflation in the U.S. was part of 1954, which is to say that a few generation have no knowledge of anything other than an inflationary environment and take it to be the absolute norm.

    My perspective is simply that there are real economy limits to credit inflation and that, after decades of intense use with accompanying accumulation/overaccumulation of debt, to which we must add financial globalization, the various countercyclic policies have been ceasing to function and with this, a returning to the more classical business cycle in which the contractionary side was almost always and evidently deflationary.

  34. VJ commented on Oct 24


    If you paid any attention to CNBC you would know the number of people who believe in a free lunch is legion.

    Oh yah. They gotta have the Purple Kool-Aid on tap over there.

    Erin Burnett was on the ‘Chris Matthews Show’ over the weekend. She said:

    “You know what, Chris ? Do you know the stock market has doubled over the past five years ? You wouldn’t even know it, because nobody’s even aware of the strength of the economy, the strength of the stock market”


  35. blam commented on Oct 24

    From the Wash Post……

    “At one point in the summer of 2006, Hunter controlled up to 70 percent of natural gas commodities on Nymex that were scheduled to supply companies and homes in November of last year and more than 40 percent of contracts for the entire winter season, according to a report into Amaranth’s activities by the Senate permanent subcommittee on investigations.

    His positions were so big he could cause the price to move in the way he wanted by buying or selling massive amounts of his holdings in the last 30 minutes of trading on Nymex, a move known as “smashing the close,” federal regulators say. ”

    Speaking of non-core inflation. The single biggest cause is unregulated manipulation and domination of the commodities markets by, you guessed it, hedge funds and wall street banks. The concept of a free “futures” market, in the classical sense, is laughable. Every morning, the futures pit manipulates the stock exchange opening and each afternoon, the close.

    I am no fan of core inflation. Until these markets are regulated by something other than the dogshit CFTC, consumer gouging through the paper based commodity exchanges will continue.

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