Warning: America Headed toward a 'Currency Cliff'

Compared to other developed countries, the American economy has an advantage in that there is still a relatively liberal amount of growth potential. Whether or not there will be any future change of direction in Federal Reserve monetary policies depends entirely upon the necessity and costs involved in maintaining low long-term interest rates. Despite the fact that recently, Federal Reserve Chairman Ben Bernanke made an exhaustive argument in favor of the Fed’s debt purchasing plan, expressing his wish to maintain quantitative easing, but following the progressive growth of internal economic motivators as well as concerns within the Federal Open Market Committee about the large-scale asset purchasing plan, the probability of an early termination of quantitative easing is growing exponentially.

First of all, the necessity for the Fed to continue unlimited quantitative easing has reduced considerably. At this point, having launched three rounds of quantitative easing, the Fed has issued a total of approximately $3.5 trillion in debt purchases that occupy nearly 22 percent of the total GDP, and has pushed the effectiveness of quantitative easing nearly to the limit. Quantitative easing is gradually losing its stimulus effect. The first round of quantitative easing (QE1) caused the real GDP growth rate to increase from -3.3 percent to 2.2 percent compared to the same period from previous year. But after the second round (QE2), there was actually an economic decline, the real GDP growth rate slipped from 3.5 percent to 1.6 percent, and although the Fed subsequently launched procedures to rectify the situation, as well as the third round of quantitative easing (QE3), the economic growth rate is still hovering around a low level of 1.5 percent. The automatic debt reduction mechanism, or the “Sequester” has begun. Public services that will be cut substantially include defense, education and health care, among others. Forced debt reduction will encumber U.S. economic growth, and consequently, over the next decade there will be a reduction of $1.2 trillion worth of debt. What’s more, the costs involved can be split up over time, which will be beneficial for the establishment of long-term “financial balance.”

Meanwhile, internal economic growth forces have begun to strengthen, employment rates have gradually started to improve and there has been a turnaround in the domestic manufacturing industry. In Q4 of 2012, U.S. industrial output indicated a 1.0 percent increase as compared to the previous year, and an increase of 2.2 percent over the previous December. However, this is still 1.9 points lower than December 2007 when the U.S. economy fell into decline. U.S. real estate market recovery has been firmly established and has warmly welcomed the best housing sales situation since the beginning of the financial crisis. Data shows, as of December 2012, average housing inventory prices stood at $180,800, representing an increase of 11.8 percent over December of the previous year. That same month second-hand housing inventory decreased 8.5 percent. The previously troubling unemployment problem has shown particular improvement. The non-agricultural unemployment rate dipped below the 8.0 percent level for three consecutive months. The necessity of continuing unlimited quantitative easing is already on the decline.

So far, Obama’s second term has been spent actively exploring the potential for U.S. economic growth (through the promotion of R&D, education and the development of infrastructure), pushing for domestic re-industrialization policies like strategic “energy independence” and a “return to manufacturing.” Industries that are predicted to benefit from technological innovations include machine, auto, aircraft and aerospace parts. Computer exports have shown marked and sustained increases, and have contributed strongly to the reestablishment of American competitiveness.

Secondly, the expense that the Fed has taken on with quantitative easing is astronomical. Looking at it from the American perspective, long-term quantitative easing has brought additional risk to the Fed’s balance sheets. Since the financial crisis began, the Fed’s pre-crisis balance sheets stood at less than $900 billion but has subsequently soared to $3.078 trillion — an increase of more than three times. If, for the remainder of the year, the Fed continues with quantitative easing, its balance sheets may very possibly exceed $ 4 trillion.This rapid inflation means that the Fed’s yearly interest payment on bank reserves will be $50 to $75 billion, and even now the scope of its reserves has exceeded $1.6 trillion. If the Fed continues purchasing assets at the current rate, within one year its reserves will increase by an additional $1.0 trillion.

Moreover, in the past, the Federal Reserve had transferred all profits — to the tune of $291 billion — over to the U.S. Department of Treasury. Due to the fact that financing costs are at an all-time low and the interest on the newly issued debt is relatively low, these factors together have weakened the desire to implement fiscal consolidation and reformation, and so, solving the problem of fiscal sustainability has been put off by the U.S. government. With its influence on long-term macroeconomic and financial stability, monetary authorities need to seriously reevaluate the costs and potential risks involved in quantitative easing policies. These factors have all had a hand in increasing the possibility of quantitative easing coming to an early end and leading to predictions that the Fed will begin to gradually reduce asset purchases and make preparations to implement withdrawal strategies.

The Fed will most likely choose to end quantitative easing earlier than first anticipated, which only elevates the probability of a future “currency cliff” that could ransack the U.S. financial market. If the Fed were to reduce or even launch any asset purchasing, the massive rise in yields would inevitably drive mortgage rates up and up, and a sharp spike in mortgage rates would likely force the real estate market, consumption and the U.S. economy into a corner where it would take another round of severe beatings. Moreover, If America begins implementing withdrawal procedures it will inevitably push the U.S. dollar to mid- and long-term appreciation, which will have profound and far-reaching implications on worldwide liquidity, capital flows and the world financial market. Once the effects begin to sink in, the sudden drying up of liquidity would cause the U.S. dollar to rise in the world currency market. Falling worldwide risk asset prices and deteriorating international capital flows would trigger another financial crisis, the magnitude of which must not be underestimated by any of us.