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