Some bearish news for the dollar

Since I wrote the 3-part piece about the dollar (parts I, II, III), some nasty things have occurred in Washington. It was just one-month ago that I made the following warning in "Part III: Can the Dollar Weaken Anyway?"

"Another very bad outcome for the dollar may happen if Congress starts dismantling the Fed’s independence"

Guess what? Since then, Rep. Ron Paul has pushed legislation which removes a certain amount of political independence from the Federal Reserve. Some of the legislation floating around (not just Paul's) specifically involves changes to how the FOMC members are chosen. By way of explanation, the Federal Open Market Committee (FOMC) is the body within the Fed system that determines monetary policy. The 12-member FOMC is composed of the 7-member Board of Governors and 5 of the 12 regional Fed bank presidents.

Here is where it gets a little tricky. The Board of Governors oversees the entire Fed system. It's 7 members are appointed by the President and confirmed by the Senate- a political process. In conjunction with the 5 rotating regional presidents, they compose the FOMC. The 12 regional Fed banks each have a 9-member board of which 3 are chosen by the Board of Governors and 6 by the region's member banks. That's right, the regional bank boards are two thirds chosen by the member banks- a nonpolitical process. Ultimately, you should reasonably end up with 7 politically chosen FOMC members and 5 industry chosen members. Given the terms of appointments, this provides a nice balance of power not usually subject to the whim of Washington. Pretty slick mechanism for balancing power huh?

This is not a mechanism that needs to be tinkered with. Political independence is key. Could Paul Volcker have raised interest rates to levels high enough to break the inflationary spiral in the early 1980's? Would interest rates remain low in election years only to be hiked after? Could politicians really be expected to prescribe the tough medicine of high real interest rates and a slow economy (even possibly recession) required to control inflation? Consider the following analysis "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence" by Alisna and Summers (1993) (yes, that is the Lawrence Summers):



If there is one thing Congress has certainly proved, it is its ability and willingness to be consistently fiscally irresponsible. That much you can count on. Such populist legislation is a definite negative for the dollar. How it plays out remains to be seen though.