Before reading this report, please watch this video.
The familiar slogan of investing is this: "Timing is everything." If true, then Ben Bernanke had a bad week. Calling it a bad week barely does justice to it.
On November 2, the American people went to the polls in the greatest numbers in history for a mid-term election and threw out Democrats in the House of Representatives. If the Senators had all been up for re-election, the Democrats would have lost their majority. It was the largest reversal in the House since 1938, when Roosevelt's Supreme Court-packing scheme led to a huge veto at the polls by Republicans – an event not mentioned in the (universally) pro-Roosevelt history textbooks. The textbooks do admit that Roosevelt knew that he had gone too far. He never mentioned the plan again. It was the only major defeat of his Presidency.
The political signal on November 2 was clear. Obama had the good sense to back off the next day, calling for bipartisanship. That is what Presidents do when they are hammered at the polls in full public view. "Let's work together, so that I can get at least part of my agenda enacted" replaces, "Sit there and take it, losers! I've got the votes." He no longer has the votes.
On November 3, Bernanke announced a $600 billion program to buy mid-range Treasury bonds in order to lower the interest rate on these bonds. Yet these bonds have been holding at their lowest rate in the post-World War II era.
On November 4, he defended himself in the Washington Post in an op-ed piece. This is the first time I recall a FED Chairman going directly to the government employees who inhabit the Washington Beltway in order to defend a policy change on the day after the change.
On November 5, word came from central bankers around the world that this move was a huge mistake. The finance minister of Germany called the decision "clueless." I have followed Federal Reserve affairs for over four decades. I never recall language this harsh aimed at a Federal Reserve Chairman by any senior foreign public official. The German official was not alone. Central bankers from around the world protested.
On November 5–6, Federal Reserve officials held a conference on Jekyll Island: the 100th anniversary of the secret meeting at which the conspiracy to create the FED drew up the final plans. Their penance was to be forced to listen to insufferably boring academic papers on utterly useless historical topics.
On November 6, Bernanke spoke at this meeting in defense of his decision to inject $600 billion into the economy. His speech was not posted on the FED's site as of the morning of November 8. The Web staffers were at home over the weekend. The media therefore could not find out what he said, or even that he had spoken.
On November 6, President Obama arrived in India as part of his attendance at the G-20 meeting of finance ministers and central bankers in South Korea this week. He will walk into a firestorm of resentment over Bernanke's announcement.
All in all, it was a remarkable week for Bernanke.
LOW, STABLE INFLATION
Bernanke is facing a slowing economy. All those green shoots he said he could see in 2009 have begun to die. Unemployment remains high. It shows no sign of coming down. But consumer prices have been flat, which allows him some breathing room. The adjusted monetary base in early November was no higher than it had been in early November 2009. The FED had at long last achieved a semi-stable-money environment. But, like a dog and its vomit, Bernanke could not stay away from monetary inflation.
In his Washington Post article he was his usual Keynesian self.
The Federal Reserve's objectives – its dual mandate, set by Congress – are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills. When, exactly, was the Federal Reserve System told by the government to produce "low, stable inflation"? Here is the Wikipedia summary of the Employment Act of 1978, the famous Humphrey-Hawkins Act.
The Act set specific numerical goals for the President to attain. By 1983, unemployment rates should be not more than 3% for persons aged 20 or over and not more than 4% for persons aged 16 or over, and inflation rates should not be over 4%. By 1988, inflation rates should be 0%. The Act allows Congress to revise these goals as time progresses.
So, has Congress recently mandated "low, stable inflation"? I am unaware of this. Bernanke did not mention the declaration in which Congress mandated this. I can tell you this much: the Congress of 2011 will not mandate low, stable inflation.
The goal of low, stable price inflation is the goal of all Keynesians. Whenever price inflation falls much below 2% per annum – a doubling of prices every 36 years – Keynesians begin to get nervous. They think that anything approaching stable prices is a harbinger of economic stagnation or even recession. Their motto is: "Better a little inflation than high unemployment."
This is why Bernanke persuaded nine other FOMC members to accept his program of monetary inflation. Only Thomas Hoenig protested – the lone vote against him for months. When the FED's program fails to bring either economic growth or low, stable inflation, Hoenig will be the obvious choice to replace Bernanke in 2014. Only his age (64 today) may disqualify him.
The assumption of all Keynesians is that price deflation is always accompanied by economic recession. They do not recognize that a stable money supply produces slowly falling prices in an economy marked by increasing output. Put another way, this scenario is "more goods chasing the same amount of money." Like falling computer prices, most prices tend in the direction of decline when the money supply is stable.
PRICE DECLINES AND INCREASING OUTPUT
The idea that falling prices accompany recession is the result of historical circumstances. Prices fell in the Great Depression because fractionally reserved small banks went bankrupt, 1930–34, thereby shrinking the money supply. Consumer prices fell because the money supply fell. The stable monetary base of the Federal Reserve in these years was offset by failing banks.
The Federal Reserve System was set up to protect big banks from bank runs under the gold coin standard. All central banks exist in order to protect the interests of the big banks. The Federal Reserve carefully intervened to protect big banks, 1930–33. Over 9,000 small banks went under until the FDIC was created in 1934 in order to protect depositors' interests. After that, the bank runs ceased. Depositors stopped worrying about the solvency of the banks.
Consumer prices fell in the United States for a generation after the restoration of the gold coin standard in 1879. Western economic output increased dramatically in the 19th century – the first sustained period of economic growth in recorded history.
The idea that falling consumer prices are an indicator of economic stagnation is widespread today. But stable prices and increasing output can go together. They have in Japan over the last two decades. Yet Japan is the favorite bogeyman for Keynesians. We are told of deflation in Japan, which in fact has not taken place over the last 17 years. In real estate, yes. The bubble popped in 1990. But consumer prices have been flat. At the same time, output per worker has increased steadily, year after year. The recessions of 1997 and 2009 were the only exceptions.
The Federal Reserve is Keynesian. It is sitting on top of a mountain of reserves, yet prices are stable. The commercial banks are not lending. The result has been a sharp reduction in the M1 multiplier until recent months.
PUSHING ON A STRING
With the new injection of fiat money – an increase in the monetary base by about 30% – under normal circumstances, Federal Reserve forecasters would expect a comparable increase in consumer prices. Yet Bernanke assured us that he does not believe that prices will rise much above a 2% rate. In his defense of the decision, he wrote:
Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run.
He does not expect rising prices. Why not? He described the current situation – excess capacity – but he offered no explanation.
Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating.
Why is there excess capacity? Because economic plans that were based on Keynesian economics did not see the 2008–9 recession. Entrepreneurs kept building plants. Then the bottom fell out.
Today, excess bank reserves are the cause of excess capacity. Businesses don't borrow, and banks don't lend.
Bernanke never used the words, "excess reserves." But he did describe their effect.
Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation.
In other words, he really believes that, because the FED got away with more than doubling the monetary base in 2008–9, it can get away with this again.
He offered an explanation for his belief that this new policy will be effective: lower mortgage rates.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance.
Mortgage rates are already the lowest they have been in the post-World War II era. The idea that demand for homes will increase because the FED pushed down 10-year Treasury rates is indeed clueless. Mortgage rates are more likely to follow the 30-year Treasury bond rate, but most observers think the FED will not be buying these long maturity bonds. On November 3, the 30-year T-bond rate was 4.09. On November 5, it was 4.12. Rates for all other maturities fell slightly.
When the policy works, he promised us, the FED will then reverse it.
We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable. But if it will take a 30% increase in the monetary base, on top of what was added in 2008–9, to get this economy rolling again, how will the FED be able to unwind these positions – i.e., sell Treasury debt – without pushing the economy back into recession?
The FED added to the monetary base at an unprecedented rate in 2008–9, yet the recovery is already fading. He thinks another 30% increase will get the job done in the job market. That will reverse the looming decline. Why? For how long?
THE FAILED RECOVERY, 1934–40
The dual Keynesian solution of Federal deficits and central bank inflation has barely had an affect on the economy. He is now doubling down the bet. He and his colleagues are risking the decline of the dollar in international currency markets. For what? A couple of percentage points fall in the unemployment rate? There is no way that there is going to be any more than this, given the inability of a more than doubled monetary base to push the rate down.
The policy-makers at the FED are facing something the FED has not faced since 1934: an economy that does not respond to a dramatic increase in the monetary base. The bankers are thwarting the FED's policy. We have seen this before: 1934 to 1939. The FDIC contained the bank runs. The number of banks stabilized. At the same time, the FED increased the monetary base by 100%. The money supply increased by 50%.
Despite this sharp increase, the economy fell back into recession in 1937. It did not get out of the Great Depression until 1940, when British orders for weapons began hitting the economy. Then the mass inflation of the war years, coupled with price controls and rationing, converted the inability of Americans to afford to buy consumer goods because of joblessness into the inability to buy consumer goods because of shortages. This was regarded by bright young Keynesians as a great victory for the New Deal. It still is.
The FED's policy of stable money, November 2009 to November 2010, did not crash the economy. There was some growth. The consumer price index approached zero percent, which has been a great gift to American consumers – one not experienced for over five decades. But the temptation to inflate was too great for Bernanke and his Keynesian peers.
They have announced to foreign holders on Treasury debt that they don't care if there is some decline in the dollar's value. Maybe they think that the other central banks will follow suit. But will those banks continue to buy Treasury debt? If they do, they are committed to mercantilism to a degree not seen in the past. They will be saying to the FED, "You called our bluff. We will race you to the bottom. We will still buy T-bonds in order to keep our currencies low." If they do this, the world is headed for a currency war, pure and simple.
The G-20 nations' representatives will huff and puff. That is for public consumption back home. The test will be their willingness to back up their rhetoric with action: no more Treasury debt purchases. Maybe even the sale of some dollar reserves.
If they take the path of business as usual, which I think they will, this will be bullish for commodities and bearish for corporate bonds.