Stage 9 – The Fed Reduces the Money Supply to Stabilize Prices

Stage 9The ninth stage of America‘s Financial Endgame™ will occur when the Federal Reserve finally takes action to stabilize prices.  This will not come in anticipation of runaway inflation, but after the inflation has been running at full speed and is out of control in the economy.  The move to reduce the amount of new money in circulation will not happen until many poor people both domestically and internationally have seen their standard of living erode from the ravages of inflation.

The reason for this delay is because there is no political benefit to be found from keeping prices stable.  Politicians only realize benefit when they can spend other people’s money to purchase favor with the people who elect them to office.  Since stable prices do not accomplish this goal, they are viewed as a very low priority objective by most self-obsessed people in political office.  It is true that stable prices are VERY beneficial to the economy at large, but it should be quite apparent by now that most people in political office are not the slightest bit concerned about the economy at large, unless they are able to take credit for helping it.

Stage 9aWhat this ultimately means is that the Federal Reserve will need to reduce the total amount of money in circulation through open market operations.  In a nutshell, open market operations are when the Fed either sells or purchases treasuries.  The effect this action has on the money supply depends on whether the treasuries are being bought or sold:

  • Fed Buys Treasuries: When the Fed buys treasuries, it creates the net impact of increasing the money supply.  The reason for this is because the cash used to buy the treasury gets created (out of thin air) by the Fed and used as compensation for the purchase, then circulated throughout the economy.
  • Fed Sells Treasuries: When the Fed sells treasuries, it creates the opposite effect.  The act of selling treasuries from the Fed balance sheet reduces the total amount of money in circulation as it is tendered to the Fed in exchange for treasuries in the open market.

In order to reduce the circulating money supply, the Federal Reserve will need to sell treasuries from its balance sheet.  This will place downward pressure on the price of treasuries in the open market, which will increase the effective interest rate or “yield” on these debt instruments.  By reducing the amount of money in circulation relative to the total amount of goods and services being produced by the economy, this will place downward pressure on prices.

However, it will simultaneously place upward pressure in the interest rate for mortgages, credit cards, business loans, corporate debt, and government debt.  Increases in interest rates can have a very significant stifling effect on economic growth, which is the key reason why the Fed is all but certain to wait far beyond when is most prudent to make the decision to reduce the money supply.  There is absolutely no desire on the part of the political establishment to take any action that will involve short-term pain for long-term benefits.

If the money supply is managed more prudently, it is possible that a financial collapse can be avoided.  The reason for this is because a prudently managed money supply would result in more free market prices for interest, debt, commodities, and other fundamental economic items.  When the economy moves based on free market prices, it self-corrects to allocate capital toward its highest and best use through independent players seeking the best return on investment that they can achieve.

When the government intervenes in the market for an extended period of time, it skews prices away from their free market equilibrium.  This creates the net effect of allocating capital away from its highest and best use, and toward whatever purpose is being artificially encouraged through government policy.  The typical excuse given for this activity is to “Smooth Out” the business cycle.  Unfortunately, when multiple years of artificial prices create incentives for poor investments, the result is frequently a crash, a crisis, and a broken economy.

In the next chapter, we will examine the effect that this action will have on the yields for Treasuries, and the chain reaction that it causes.

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