The Fed's Incredible Credibility

The FED’s Incredible Credibility by Michael S. Rozeff The old Wall street adage is “Don’t fight the FED.” It advises speculators not to speculate against the market trends being caused by the FED because the FED has deep pockets. If no one fights the FED and everyone acts as if the FED is credible, even if they secretly believe it is not, then the FED gets its way in the stock and bond markets. It makes and breaks prices when it wants to. It makes and breaks bubbles. Intelligent speculation based upon real values is supplanted or at least greatly diminished in favor of FED-watching and FED-following. There is a problem. What if the FED’s credibility vanishes? Reality sets in, rather than the FED’s ability to get its way and manipulate investor beliefs and/or action. At that point, a market suddenly cracks and prices fall. The unlucky and unwary are left holding the bag. And the FED’s credibility can vanish if it backs itself into a corner and can no longer maintain a policy. The FED has a balance sheet, like any other entity, and that balance sheet can weaken. The FED is subject to political pressures. It does not exist in isolation. Other currencies compete with the FED’s. As these pressures mount on the FED, its credibility is diminishing. The outcome will be felt on both the dollar and U.S. bonds. The time has come when it is more prudent to fight the FED than not to. There is a pressing need to know whether to fight the FED or not. We need to assess Chairman Bernanke so that we can protect our wealth against him. In an earlier assessment of mine, I focused on his bias toward collectivism. This I now believe is mixed in with a strong tendency to rely on academic research or at least rationalize what he does in terms of academic research. I size this side of Chairman Bernanke up as follows. He is a man who believes in what he believes. He tells us plainly what he believes and he acts upon it with the power he has. He does not act on instinct, intuition, experience, knowledge of history, common sense, or knowledge of human behavior. He does not act upon judgment or even what may seem like facts to you and me. He acts upon his theories and his interpretations. These are what he believes. They change as academic research changes, because he relies heavily on academic research, but they change slowly. Dr. Bernanke looks to academic research and his interpretation of that research to guide his decisions. His bailout efforts that were hastily improvised tie back to his academic beliefs about systemic risk. Chairman Bernanke has done academic work on this question of credibility. If you want to know how Ben Bernanke thinks and why he thinks that the FED can get away with massive inflation of the monetary base, I suggest you read the first part of this speech of his. But since Bernanke speaks in academic professorial tongue, you may need to translate it into plain English. I will do some of that as I explain what I think he’s saying. In his speech, Bernanke unequivocally and very strongly promotes the control of inflation. He

wants to be seen as a credible inflation-fighter, despite the fact that the FED has been established in order to create inflation of its bank notes and has succeeded at that task (see here.) The dollar would not have declined so severely against gold had it not succeeded. He begins by praising inflation control: “As you know, the control of inflation is central to good monetary policy. Price stability, which is one leg of the Federal Reserve's dual mandate from the Congress, is a good thing in itself, for reasons that economists understand much better today than they did a few decades ago.” Bernanke equates inflation with increases in some selected indexes of prices, mostly the CPI. Price stability of some price index or other is a deeply erroneous focus for monetary policy. Holding some selective index steady, when it should be falling in order to correct economic imbalances, requires the FED to inflate its notes. Consequently the FED in such a case is pursuing inflation and thinking that it is not inflating. Or what is worse, it is trying to make us believe that it is not inflating when it knows that it actually is inflating. Price stability is a treacherous guide to the production of money by a central bank for other reasons. There are many millions of prices, always changing. There is no way to construct a measure of prices without introducing subjectivity. Indexes like the CPI ignore asset prices. Asset prices can move faster than consumer goods prices and in directions opposite to them. There are lags and frictions in the changes in prices. The measurement of prices is fraught with difficulty, and people alter their buying and selling behavior as prices change. Prices can fall when productivity increases, and there is no good reason for trying to make them stay up. Let us walk on this shaky turf of price inflation and get to the question of credibility. He says “Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability.” This means that if we the people look at consumer price indexes and if we think that these indexes are stable, then we will be thinking that the central bank is controlling inflation. We will think the FED is a credible inflation-fighter. We will not doubt the dollar and sell off dollar securities. We will not buy gold, hard assets, and stock up on consumer goods. We will not sell off bonds. We will not seek out stronger foreign currencies. If we did, we would cause bond prices to decline and interest rates rise. We would drive the exchange rates down. We would drive the prices up of those goods and assets we decided to buy. Bernanke wants to be able to inflate FED bank notes while keeping us holding on to them and spending them steadily in our usual ways so that the consumer price indexes do not inflate or inflate wildly. He is like a magician who wants us to look at his left hand while with his right hand he extracts a rabbit from his vest. Bernanke does not want us to lose confidence in the bank notes he is printing and spending, even if he’s printing and spending a great deal of them. “So, for example, if the public experiences a spell of inflation higher than their long-run

expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored. If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.” Bernanke wants us to think of inflation as price inflation, and he wants us to ignore price inflation so that he can print more bank notes. Our ignoring price inflation is what he means when he looks for “inflation expectations [that] are well anchored.” Next, he says that we don’t know what’s going on: “Although variations in the extent to which inflation expectations are anchored are not easily handled in a traditional rational-expectations framework, they seem to fit quite naturally into the burgeoning literature on learning in macroeconomics. The premise of this literature is that people do not have full information about the economy or about the objectives of the central bank, but they instead must make statistical inferences about the unknown parameters governing the evolution of the economy.” When Bernanke says that people don’t have full information about the objectives of the central bank, he means that we don’t know what’s going on in this game. This is true. The vast majority of people have no idea what a central bank is or what a central bank does. This allows the central bank to fool most of the people most of the time. The speculators who do know don’t fight the FED in the main. The central bank, the government, the educators, and the economists do not enlighten the public about this matter. They mislead. A handful of Austrian economists and politicians like Ron Paul attempt to educate the public. Bernanke definitely does not want us to think of inflation as the FED’s own bank note inflation. He definitely does not want us to view the FED’s printing of the FED’s bank notes as linked to or causing price inflation. He never mentions this. He gives the central bank credit for not causing price inflation when he says “...better-anchored inflation expectations--themselves, of course, the product of monetary policies that brought inflation down and have kept it relatively stable...” This is a tacit acknowledgment that the FED can cause price inflation. For if the FED can bring inflation down, then it can bring it up. Dr. Bernanke surely understands that the FED not only can cause inflation (is a sufficient cause) but is the only necessary cause of a long-lasting inflation such as we have experienced. But he cannot ever acknowledge the necessary causation of the FED publicly. To do so would tie his hands. Instead of appearing as the knight slaying the dragon of inflation that appears out of a cave, he would become the dragon himself and be asked to turn in his fire-breathing apparatus. In Bernanke’s Keynesian thinking, price inflation is caused by the public’s own volatile inflation expectations when prices of such items as oil and food jump around. He specifically mentions

“a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent ‘wage-price spiral.’” In the same vein, he mentions “...if inflation expectations are well anchored, changes in energy (and food) prices should have relatively little influence on ‘core’ inflation, that is, inflation excluding the prices of food and energy.” He also speaks of supply shocks that cause inflation. These are all imaginary dragons charging out of imaginary caves and mountain recesses, or emanating from oil cartels, crop failures, weather, and labor unions not to mention greedy companies and overpaid executives. The single most important fact that tells Bernanke that inflation expectations are well anchored is that interest rates have not been rising as they did in the 1970s when price inflation increased. The FED’s success in his mind and that of his predecessor rests on the fact that interest rates have fallen for over 20 years and are now low. He attributes none of this to the FED’s own power to create note inflation and bond market bubbles that seriously inconvenience any short sellers of bonds who fight the FED. Interest rates are where this war is fought. It takes 3 times as many dollars to buy the CPI’s adjusted goods as it took in 1979. The price inflation has been a minimum of 3.7 percent per year. The 10-year U.S. Treasury bond in the last month yielded between 3.21 and 3.57 percent. If this market were operating without the FED’s interference, at what level might yields be? If the real return were 1 percent, the term premium at 1 percent, and inflation compensation at 3.7 percent not even counting taxes and capital gains effects, then the rate would be 5.7 percent. That is a minimum. The FED’s success at anchoring inflation expectations is illusion. It implicitly assumes a kind of stability in investor and public beliefs that is not there. It assumes a kind of normal distribution with a low probability of large outliers and sudden large changes. Social beliefs can change rapidly and sharply as perceptions lead to changes in consciousness. One day people may believe in Obama’s hope agenda, and a few months later they may change their opinion. Bernanke or one of his successors is in for a rude awakening when the magic of their market manipulation no longer works and when the credibility of the FED drops sharply. They do not understand that markets can alter prices very suddenly and sharply for no apparent immediate reason but after a buildup that takes time. When that happens, they will blame us for having unanchored inflation expectations! The FED’s success is at blowing up bubbles and sustaining them for years, well beyond what might have been expected. This success has been because it has gotten in bed with bond dealers and they in bed with the FED. The FED is a major player in the bond markets. It succeeds in holding down yields because the FED can influence bond prices and the major players do not fight the FED. Not many people fight trillion dollar injections of liquidity into the bond markets. The bond market is out of kilter with past price inflation and out of kilter with the FED’s recent

massive note creation. The FED’s own bubble creating power is the reason why it looks to Bernanke as if inflation expectations are well anchored when he looks at yields on government bonds to assess these expectations. Asset markets and their prices can be heavily influenced by powerful players with deep pockets for considerable periods of time. There is inertia in people’s buying and selling, and there is illiquidity. Prices can react with considerable time lags. Inter-market relations can be out of sync for lengthy periods. One cannot look to prices and expect to be able to understand their every move or relations to one another. Eventually they get to where they are going, despite the weighty influence of any single player. That will happen in the bond market. The problem of credibility is a problem not just of the FED but of all central banks and all governments. There exists a gap of believability between what they say they are trying to do and what they actually cause to happen. Their stated ideal aims and the results do not mesh. To anyone who thinks about it, the U.S. government has little or no credibility in that its freedom-rhetoric is totally falsified by its actual actions. What thinking person believes what any leader says he is accomplishing for America’s good when the actions almost always prove otherwise? There are not good and strong ways to hold these leaders to sound policies. There are no workable devices that uproot and cast away their policies when they fail to being about their promises. Ordinary electoral methods, the two-party system, and voting work to bring about unsound policies. The constitutional-electoral-democratic system lacks commitment devices that force leaders to commit to the right policies and stick to them. This is the basic reason for their rhetoric’s lacking credibility. They cannot be held to stick to what they promise. The FED is really just another government agency. If it speaks of fighting inflation, its words cannot be believed at all. The legislation that creates its rules and incentives does not institute any commitment devices to assure that it will fight inflation. Just the opposite. The law that required the FED to maintain 40 percent gold backing of the notes it issues was repealed a long time ago. It was replaced by a mandate to get the economy up to full employment. The economic theory behind the idea that monetary policy should help control employment is deeply flawed, plus the institutional rules do not commit the FED not to inflate its notes. The FED has zero credibility as an inflation fighter from the get-go, and of course the facts of dollar depreciation back up this way of looking at the question of credibility. It is only a matter of time before the FED’s incredible credibility goes into its own bear market along with the bond market. November 7, 2009