The Fed's Bluff

The Credible Threat

Last night I reread the text of Bernanke's Fed speech on deflation (Deflation: Making Sure "It" Doesn't Happen Here). I remember the first time I heard his printing press remarks -- I was blown away. I didn't know who this guy was, other than that he was a new guy and that I thought the line about the printing press was an extremely irresponsible thing to be saying. I was sure that he would be fired, or at least repremanded for his remarks, but look where he is now. Shows you how much I know.

This is what I gleaned from the speech last night: Bernanke tells a story, that if an alchemist invented a way to make gold in unlimited quantities, then released this news to the world and said he was going to start making and selling unlimited amounts of gold, the price drop immediately, before the Alchemist made or sold a single ounce. He goes on to compare the Fed to that alchemist. He talks about the printing press, then says, "By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services."

Then it struck me - this elimination of M3 in March is the credible threat.. Its a bluff. First they juice M3 like it is the end of the world (or 1999), and then they turn the lights out on the statistics. Since we're all in the dark, the only thing we can assume is that the Fed is monetizing debt like there is no tomorrow. But they really don't want to do that -- it is not good for their balance sheet -- so instead they engineer this bluff. Everyone believes it, and they (we) act accordingly, bidding up stocks and gold.

If you don't think the Fed is that clever, I encourage you to read Bernanke's speech. It is a long treatise on stimulating demand and causing inflation in the event that interest rates fall to zero. After reading the speech, you may find that they are beyond clever. They are insane!

I guess I wasn’t exactly clear about the nature of the “bluff.” Not that M3 is being bluffed higher - it seems pretty clear that it is rising now, and I don’t question that.

But I still think that the Fed is more concerned about deflation than inflation. As I mentioned, I was reading the Bernanke Deflation speech - Making Sure IT Doesn’t Happen Here - which he gave in late 2002. It is clear that the Fed was worried about deflation all the way into 2003, until the war started and solved the problem, at least temporarily.

Just before I read Bernanke’s speech, which is filled with all kinds of schemes for producing inflation, I ran across this very curious article on the web:

“WASHINGTON, Jan 4 (Reuters) - The Federal Reserve has several ways to boost the economy even if official U.S. interest rates were ever to hit zero, but the public needs to understand them to make them effective, a new Fed study says.

“Two researchers at the Federal Reserve’s Board of Governors used the U.S. central bank’s economic model to evaluate some strategies that economists have suggested to get around the fact that rates cannot be pushed into negative territory.”

Sounds interesting, right? It lists some policies, then at the end, it finishes off with this:

“However, the effectiveness of the alternative policies deteriorated sharply when the expectations of businesses and the public were based instead on historical experience.

“They said their results suggested that a central bank that operates with a low inflation target, which makes the risk of deflation more pressing when the economy weakens, may want to adopt other accompanying policies before crisis strikes to allow time for the policies to become understood. ”

Listen to the focus on “expectations” and how the Fed “may want to adopt other accompanying policies before crisis stikes.”

So how can they manage expectations, and what other policies can they adopt? Greenspan has said in the past that he finds the notion that the Fed can prevent recessions “puzzling” because they are caused by “human psychology.”

Everyone believes that the Fed is hiding M3 because they want to hide massive inflation. But it is such an obvious thing to do. Because it is so obvious, I suspect that there is another reason, that is less so. I thought that maybe there is a paradigm shift going on at the Fed, realizing that it is all about perception and emotion, perhaps they are trying to manipulate that since strict monetary tools don’t seem to be doing the tricke. So my mind put all of the above together in one of those flashes of insight that is either brilliant or ridiculous. In short, the nature of the bluff that I saw in my mind’s eye at that instant is that the Fed is in fact trying to hide an impending deflation by disappearing M3!

How popular will that Iranian oil bourse be? Who knows? But if a number of countries start buying oil in euros, all those overseas Eurodollar accounts will become redundant. When they are closed, M3 will show a big drop - deflation - which would spook the global economy more than inflation.

If you noticed, consumer credit fell for the second month in a row - deflation. There are other signs of it here and there, but the potential for the oil bourse to be deflationary is somewhat larger, don’t you think?

I am happy to entertain opposing opinions, because I’m not completely convinced that my reasoning is sound.

Anyone here have any comments on this? Everyone seemed pretty smart and well informed last time. -dirk

Welcome to FreeRepublic.

My take: Sooner or later the Federal Government (and many State governments) will conclude that a burst of hyperinflation will be in their best interest.

They want to pay back debt with cheaper dollars. They want to pay Social Security and government pensions with cheaper dollars. (They figure that COLAs will not, indeed cannot, keep pace)

Thanks for the welcome, Ben.

My question is that why do we assume that the Fed can produce inflation at will? Japan was stuck in deflation for 13 years - maybe they're out now, but maybe not.

It seems what Nystrom is saying is that deflation is more of a psychological thing than a money thing, and the Fed has realized that, so they're acting accordingly - i.e. messing with our heads.

IMHO, I think you are being too smart by half. Deflation isn't and hasn't been a legitimate fear. Yes, there's been a lot of talk about it, but I don't see it happening and I don't think the Fed does either. Inflation is a concern, but not a huge one. The Fed STILL does not fully believe that we can grow at 5% to 6% without the fear of inflation, but productivity and technology say we can. Cheap international labor says we can. But the new head of the Fed IS flexing his poker playing skills.

I think the Fed is still pretty worried about deflation. Just take a look at Bernanke's speech from 2002:

http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Greenspan was talking about it as late as early 2003. The only thing that saved us from deflation IMHO was the War. That kicked up government spending big time.

Have you noticed that consumer credit has fallen now two months in a row?

I agree tht there is a large psychological component.

It has been decades -- yet I still remember the sense of urgency that consumers felt during the inflation of the 70s. People were literally concerned that if they didn't buy a product 'this weekend' then by 'next weekend' the price will have gone up.

Similarly, consumers accepted higher rates for borrowing on the assumption that the debt would be paid back 1) with cheaper dollars and 2) based upon an inflation adjusted wage.

The latter, I think is the key. Wage inflation is what will get the ball rolling. Price inflation will inevitably follow.

Given enough stimulus the economy will require additional labor. The resulting competition for labor will lead to rising wages.

The Fed is going to stop reporting M3 in March of this year. See this excellent article on Oil, M3 and Iran:

http://www.dailykos.com/storyonly/2005/12/27/115725/53

I knew from reading that the M3 was to be discontinued. However I thought that back in the 50's or 60's Congress passed a law requiring that the FRB publish it, and others. I didn't know the law had been repealed. Thanks.

Given enough stimulus the economy will require additional labor. The resulting competition for labor will lead to rising wages.

Here's the "yes, but". The incredible productivity of the U.S. and cheap global labor (almost unlimited labor pool from China and India) will allow the U.S. economy to grow at a stronger rate than it could historically before inflation kicks in at a greater-than-acceptable-rate. That is the real "new economy" that Mr. Greenspan wasn't fully sold on, but seems real for the forseeable future.

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