Monday, December 7, 2009

Bernanke's belief system not encouraging

Fed Chairman Bernanke this morning attempted to answer everyone's most pressing concerns about monetary policy, the economy, and inflation. His answers revealed a lot about his belief system, and from my perspective he has some problems. There's really nothing new here, but it's worth repeating because this is a subject that has enormous importance for just about everyone in the world, given the Fed's power and influence.

Bernanke is fundamentally a Keynesian when it comes to the economy: "a sustainable recovery requires renewed growth in final sales," he notes. Not a word about how the economy is going to produce and earn more in order to purchase more. No mention of how tax or regulatory burdens might discourage new business startups. For Keynesians, economic growth is all about demand; if demand materializes, then growth will follow.

Bernanke is in charge of the Fed, and the Fed is charged with keeping inflation low and stable. Only the Fed has the power to print money and thus to create inflation. But to hear Bernanke speak, inflation depends on a variety of things that have nothing to do with the Fed:

Inflation is affected by a number of crosscurrents. High rates of resource slack are contributing to a slowing in underlying wage and price trends, and longer-run inflation expectations are stable. Commodities prices have risen lately, likely reflecting the pickup in global economic activity and the depreciation of the dollar. Although we will continue to monitor inflation closely, on net it appears likely to remain subdued for some time.
Here he reveals yet again his Keynesian roots. When the economy is weak (i.e., when there is lots of "resource slack"), then inflation tends to decline. This view, however, ignores the fact that while a weak economy may result in some price declines, the only thing that can generate a decline in the overall price level is a shortage of money. I know firsthand, from my four years of living in Argentina in the late 1970s, that a very weak economy can coexist with very rapid inflation. Indeed, rapid inflation is a major reason why hyperinflationary economies are generally very weak. Bernanke also notes that a weak dollar can boost commodity prices, and that can contribute to inflationary pressures. But why is the dollar weak? He never answers that question. If the Fed controls the supply of dollars, then surely a decline in the value of the dollar must be the consequence of the Fed either oversupplying dollars to the world, or failing to restrict the supply of dollars in order to offset a decline in the demand for dollars.

For both Bernanke and his predecessor Greenspan, the Fed never controls inflation directly. They see the Fed's job as monitoring the things that do create inflation (e.g., the health of the economy, the degree of resource slack, and inflation expectations) and then taking action if required. In this view, the Fed controls inflation indirectly by taking measures (e.g., raising or lowering interest rates, adding or subtracting liquidity to the banking system) which are ultimately designed to boost or retard economic growth or reduce inflation expectations. It's a convenient way of describing the Fed's job, since if inflation ends up being too high, the Fed can conveniently blame it on things beyond its control: inflation expectations became unanchored, commodity prices rose too much, the dollar fell too much, demand was too strong, etc.

The real problem with this worldview—the Fed's model of how inflation works—is that it doesn't focus on the monetary roots of inflation. It puts too much emphasis on non-monetary factors, and this in turn leads to Fed errors. We've seen several examples of this in the past decade. From 1995 through 2000, the Fed thought the economy was too strong, and so they tightened policy even as inflation was low and declining, gold and commodity prices were plunging, and the dollar was rising. That helped tip the economy into recession in 2001, and it created deflationary pressures which dogged the economy through 2003. The Fed then thought the economy was too weak and deflation was a threat, so they pursued a multi-year period of excessive ease in 2002-2005, even though inflation, gold, and commodity prices were rising, and the dollar was falling. That in turn helped fuel the housing bubble, the popping of which set in motion the financial crisis which precipitated the recent recession. Today the Fed is once again concerned about how weak the economy is, so they are extremely accommodative even though gold and commodity prices are rising and the dollar is falling.

As long as the Fed persists with this view of the world, they will likely err on the side of monetary ease, and that will give an upward bias to inflation. It will also likely result in asset price bubbles, one of which appears to be forming in the gold market—where, not coincidentally, prices jumped in the wake of Bernanke's speech this morning. 

Badly informed monetary policy on the part of the Fed has been an important source of the very headwinds that Bernanke today blames for creating a dismal economic outlook. It's a shame, because the Fed could have done a better job and we all could have been better off. I for one would like to see some new and better-informed blood at the Fed.


In Transition said...

Who do you suggest as a good candidate(s) for the Fed.

or are you looking for a new assignment?

Bret said...

Scott Grannis wrote: "...the only thing that can generate a decline in the overall price level is a shortage of money."

I suppose that's true by definition (assuming assets are included in the "overall price level") but it seems to me that your statement is kinda skirting around Bernanke's point. The price level of final sales in general could still be cratering even while the overall price level is increasing.

In theory, it'll all sort itself out eventually. In practice, it's moot because governments are rigged to stimulate! stimulate! stimulate! either through monetary expansion or borrowing till the cows come home or both.

The bottom line is Bernanke has no choice. The alternative to what he's doing is that the politicians become even more involved with meddling with the economy and that's far worse in my opinion.

Scott Grannis said...

OnMission: I thought you'd never ask. I am available for public service. As for other candidates, there are several I could suggest, but they would never pass the inevitable political litmus tests.

Scott Grannis said...

Bret: It's one thing for some prices to decline, and quite another for all prices to decline. Clearly, we are not in a generalized deflation, since we know commodity prices are rising significantly and measured inflation is still positive. The fact that some prices are falling is only natural given the significant deterioration in the economy and the massive restructuring underway. That is to be expected, but monetary policy should not be used to try to prevent any and all price declines. Monetary policymakers should be independent of the political process and politicians should stick to their knitting. On that score let me add that the measure of success for a Congress should be inversely proportional to the number of bills passed in a legislative session.

The Commodity Guy said...

I love your blog. It's helped me make a lot of moola in the past nine months. Thank you.
However, I disagree with you post. Money growth doesn't cause inflation in some kind of secret ceremony. There has to be a mechanism. In most of the inflations I can find in history that mechanism has been credit. As a general rule, no credit growth -> no inflation except short term cost push stuff.
So far there hasn't been any credit growth. The increase in gov't credit has just about offset private credit reduction.
Maybe this will end badly, but the results aren't in, and I think it's the odds are on the side of less inflation. The political dynamic has shifted against greater deficits, even in a bad job environment. Just wait till things get better!

Scott Grannis said...

Burt: I've posted at length about the inflation process. You are right that it is not just money growth. It is several things: setting interest rates too low, and failing to respond to market signals that money demand is declining.

A given amount of money can support a higher price level if the demand for that money declines and money velocity rises. If the Fed fails to offset the decline in money demand, then inflation is the result.

There hasn't been any credit growth over the past year because lots of people are trying to deleverage and banks are reluctant to lend. But if you look at the past 3-4 years, credit growth has been huge. Money supply growth has also been above average. These things are the raw fuel for higher inflation. I don't think we are looking at hyperinflation, but I do think that inflation will be higher than most people expect. 4-5% inflation would be very surprising, for example, since the market and the Fed are only expecting 2% inflation.

Bob said...

Scott, great thread. Thanks to all contributors.


Public Library said...

I agree with Scott 100%. The past decade or so have been prime examples of problematic Fed policy.

The current Fed members have all been apart of it yet we are not holding them accountable for their contributions.

This is akin to giving the green light to status quo with a few regulations scattered on top.

My expectations are for future volatility. We have since past the time of "Great Moderation"

tom said...

I agree. Great Post.