Busch: Tried and True QE2: $ Down

In a move that shocked the nation and the world, the Reserve Bank of Australia raised interest rates 25 basis points to 4.75%and the Australian dollar has broken parity with the US dollar. The reason provided for the action: the RBA sees a risk of inflation rising over the medium term and that past moderation in inflation close to ending. Clearly, the Australian central bankers are operating from a different model than the United States.

As we peer into the two day meeting by the Federal Open Market Committee, the room is filled with a haze of uncertainty. Federal Reserve Presidents of New York, Atlanta and St. Louis have stated clearly that they believe they must act to eliminate a deflation spiral that they predict will cause irreparable damage to the economy and employment. They advocate a program of US Treasury bond purchases per month that is approximately the equivalent of all new US Treasury bond issuance per month.

Federal Reserve Presidents of Kansas City and Dallas urge caution as the merits of a new program are questionable at best and destructive at worst. Today, former Federal Reserve chairman Paul Volcker has stated that he does not expect “overpowering results” from any policy easing by the central bank to try to revive the U.S. economic recovery.

Ben Bernanke, Federal Reserve Chairman
Ben Bernanke, Federal Reserve Chairman

While there are no model results that have enough data points to prove the validity of the potential Federal Reserve action, there is one consequence of the Fed’s actions that even a first year student of economics will understand. Supply and demand.

The Federal Reserve is going to increase the supply of US dollars in the global financial system and that should drive down the value of the currency.

With a lower US dollar, the export sector of the United States will see its competitive position improve against its trade partners. Therefore, this should stimulate economic activity and employment in this sector; it should lead to higher import prices; and hence, higher inflation.

A lower US dollar must be the central reason for the FOMC to engage in QE2. There is no other proven reason for the action. The only question remains is this: what is the target? Is it numerical or is it political? Will a lower US dollar have to drive inflation above 2% or drive the Chinese to allow a revaluation of the yuan?

Either way, the actions tomorrow by the FOMC will take it out of the realm of finance into the realm of geopolitics. It will not go unnoticed by a new Congress ready to question the activities and ask if it’s sound policy for a country to debase its currency.

Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.