All eyes are currently on US financial markets, where the Fed has offered to sink half its portfolio into mortgaged-based securities. And it is true that there is a risk that the spreading credit crunch could cause great economic trauma. But don’t forget about the dollar. It is now trading at over 1.55 to the Euro after another sharp bump, and no one thinks it has touched bottom. There is a second path to chaos: a potential run on the dollar. The two risks are related — the crunch could trigger a run — but not the same.
Update: Make that 1.56 to the Euro....and counting.
The nice thing about the Fed exchanging treasuries for MBS is that it is not expansionary monetary policy and need not be seen as inflationary. The not so nice thing is that $400B, the amount said to be in play, is tiny compared to the $10T or so in anticipated losses stemming from the collapse of the housing bubble. If fiddling with its portfolio is not enough and Plan B is for the Fed to flood the markets with money, expectations of inflation could be reignited, with further risks to the dollar.
So there are two abysses facing the US economy and not much policy space between them.