The Global Economy Sorts Itself Out

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The Global Economy Sorts Itself Out

The Federal Reserve controls the dollar, and the dollar rules the world.  As such, the Fed has an enormous influence on the increasingly complex and volatile global capital markets, and this has very real implications for countries all over the world. 

Many countries are vulnerable to shifts in global capital flows, particularly in this time of global adjustment as the major economies, like the United States, make globally significant monetary decisions in pursuit of their own self-interest.  Ultimately, the Fed mandate is to care for the health of the U.S. economic system, even though decisions made today in Washington will impact Indian, Turkish and Brazilian traders tomorrow.

Despite its global impact, Fed policy is only really able to take into account the state of the domestic U.S. economy, and even that is done in an environment of quickly changing data and with no ability to directly affect fiscal decision making. 

In essence, the Fed makes world-changing decisions with an inherently narrow focus, flawed data, and limited tools.  Most importantly, the very complexity of the factors in play makes it impossible for any one institution to anticipate every effect of its actions.

For the most recent example of this situation, consider the Fed's announcement in December 2013 of the long-anticipated beginning of what has become known as "tapering."

Tapering represents the end of an unprecedented monetary expansion project that was launched in an effort to stimulate asset demand and keep the U.S. economy afloat during the financial crisis.

The actual volume of asset purchases being taken off the market is relatively small.  The Fed plans to continue to purchase $65 billion in mortgages and Treasury bills for an undefined period of time, and will maintain lending rates between zero and 0.25 percent until unemployment in the United States falls to 6.5 percent, and perhaps significantly further.1

While U.S. growth in 2014 is expected to be stronger than in 2013, the Fed is not forecasting that the end of slow growth is in sight; so the process of tapering asset purchases could continue into 2015.

However, there is some urgency underlying the Fed's decision.  Monetary expansion is an important tool for any central bank, but the implications of such a lengthy expansion are not well understood.

Monetary expansion cheapens money by expanding the supply, and cheaper capital means that more countries have access to it.  As a result, several countries, including Brazil and Indonesia, developed "current account deficits" that were, in effect, paid for by financial flows fueled by monetary expansion...

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