The Fed and Gas Prices

Over the last year gas prices have increased significantly.  As easy as it is to blame greed or even the war in Iraq for the gas problems, the primary culprit is the weakening dollar due to the Fed's economic activity.  Ultimately, the falling value of the dollar contributes to increasing the price for foreign goods (such as oil) because it takes more dollars to buy the same goods.  Why is the dollar falling?  The Fed has been aggressively cutting interest rates to attempt to prevent a recession.  Lower interest rates mean that an investor earns less on their investments then before (anyone seen their interest rates on savings accounts lately?) and thus US-securities become less attractive.  Furthermore, the Fed has been dumping billions of dollars of liquidity into the system to attempt to keep the credit crisis from affecting the economy as a whole (which has not been successful).  Two days ago the Fed announced a $200 billion dollar injection to trade the bad debt of banks for dollars.  They created this money out of nothing.  You can't do that without dropping the value of money by the same amount.  And sure enough, what happened.  Within two days oil rose 10%, is now above $110/barrel, and the Euro is now above $1.55..

 

In short:

 

Cutting interest rates makes the dollar less valuable

Dumping billions of dollars of "new money" reduces the value of the dollar

Therefore, weakening dollar equals increased prices for foreign goods (not to mention the soon-to-be increases in domestic goods)

 

What is disturbing about all of this is that the Fed is attempting to protect the economy from the consequences of poor decisions, instead of letting the market adjust itself.  If a bank was unwise in its lending activity (read, made poor business decisions), natural consequences take over.  If we try to interfere with those, it just makes things worse in the long run.  By dumping money and lowering interest rates, the Fed is playing a very dangerous (and stupid) game in an attempt to stop something that is happening.  It will just make things worse and the recovery longer.  I understand that much of it is political, but it is still stupid.  Politics and economics are not a good mix.