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10/25/2005
A Bernanke Discussion, by Roger Arnold

Bernanke was chosen by the corporations years ago - and by the foreign central banks who we are beholden to now - he has championed sole mandate inflation targeting world over with the economic growth mandate for fed policy being moot except in crisis; i.e. the ECB plan - and now it is coming to the US - what is ironic about this is that he is simultaneously and erroneously considered to be a dove - but those beliefs will get shattered as his primary focus will be on protecting the value of the feds book and US treasuries in general; i.e. the value of dollarized assets being held by the foreign central banks; primarily Japan and China, but now also the UK - the fed will become an adversary of the private economy and private money creation as a result - this is where the belief in his dovish nature comes from; his attitude of go along to get along with the fiscal authorities will be embraced by the admin because he will monetize their issuance of long term treasury debt with a blank check whereas Greenspan won't - and he will then offset that monetization with increasingly higher fed funds - sound bizarre? - we are entering a world wherein it will be an antagonistic relationship of public versus private, fiscal and monetary policy versus the private economy, the fed bank members versus the fed, the fed bank members versus their clients / borrowers, big companies and the corporate state versus small companies and the private state - barriers to entry domestically will rise as access to capital is left increasingly available only to the haves - all of which is in keeping with this administration's policies to date - it will be very interesting to see how long it takes the markets to get who Bernanke is and how long it takes Bernanke to essentially re-write the fed mandate - and who, if any in Congress objects - this is not like when Volker turned the reigns over to Greenspan - they were of a similar mindset with respect to the role of a central bank - Bernanke is a new breed of central banker all together - he's gotten the job by placating the admin about their need to issue debt - and he will do it - but it will come at the expense of you and I and every member of the private economy - because for every dollar he monetizes for the feds will be countered by another dollar being removed from the private economy - that's in essence what inflation targeting is - and as sovereign debt to GDP growth accelerates all over the world the rest of the worlds western economies will do the same - bringing us finally full circle on the twentieth century - having spent it fight collectivism of all sorts and won; fascism, socialism, communism - we are now becoming that which we vanquished - but today we call it globalization.

Rudolf Hauser Responds:

There are some things in your statements that needs an explanation. When the Fed buys government securities, whether on the open market or directly from the government it does so by creating high-powered money (currency and reserves). When the Treasury spends money it receives it enters the private sector and the money supply. (Treasury deposits are not counted in the money supply.) In any case no money is removed from the private sector unless the Treasury sells securities to the public and keeps the resulting payment in its deposit account.

It is an identity that prices times real output equals money supply times income velocity. To the extent that money creation is not offset by changes in income velocity, GDP will increase. Real growth may be impacted by monetary policy over the business cycle, and the impact of an inflationary or deflationary and/or erratic monetary policy may to some limited extent influence longer-term real growth, but real growth over the longer-term is mainly influenced by fundamental non-monetary factors. As it is it is mainly the changes in monetary growth that create major changes in the inflation rate. More modest changes in inflation such as the sort currently being talked about can be due to non-monetary factors such as the supply situation in energy. When one says the Fed monazites the government debt, one means that the Fed is expanding the money supply and that is generally inflationary when it results in faster overall monetary growth. The government could buy Treasury securities and sell private securities as an offset in theory, and one might perhaps still call that monetarization. However the Fed basically holds only Treasury securities or repurchase agreements involving Treasury debt, so that is not an option. The Fed does not buy Treasuries directly from the Treasury other than to replace maturing issues it holds and will not be doing so under Bernanke. When the Fed buys in the open market another term for that is supplying Fed funds. An increase in the supply of Fed funds (reserves -i.e. deposits at the Fed) will lower the Fed funds rate from what it would otherwise be. To increase the Fed funds rate it would have to be shrinking reserves, not increasing them. Now the Fed funds rate will go up over time because inflation and inflation expectations would increase under a policy of increasing reserves, but the real Fed funds rate will not do so.

Now there are two ways the Fed can try to influence the inflation rate. It can directly set targets for the growth rate of some measure of money or high-powered money or reserves. To be effective it must make some correct assumption about any likely changes in velocity. In that case it will have no control over the interest rate. The other way is to set a short-term interest rate target and provide whatever reserves are needed to achieve that target. Whether that rate is or is not expansive depends on what the interest rate would be without Fed action as both the inflation premium and real interest rates are related to what is going on the real world. If the Fed can determine what that rate is, it can then try to change that rate in a direction that would accomplish its goals on inflation, etc. In short, what Arnold says in the first part from his statements makes no sense.

I might also note that when an expansive policy is being followed, real growth and inflation might be expected to increase. (When inflation expectations are high the impact on inflation would be more rapid than when they are low and the confidence in the Fed is high.) Then if the Fed does not increase its Fed funds target sufficiently, the tendency will be for a faster rate of reserve growth with its expansive influence on GDP and inflation, worsening the problem. This is what happened in the 1970's. Responses on prices are slower than on real growth as those who did not increase prices fast enough are still trying to catch up. So the impact of an effort to break inflation by a more restrictive monetary policy will tend to cause an economic slowdown or decline while inflation is still high and possibly increasing - what we refer to as stagflation. That can also happen to some extend even if policy just stabilizes rather than creating further acceleration as the market realizes that it suffered from money illusion and that real returns were not as great as had been assumed. A deflationary monetary policy like an attempt to lower a very high inflation rate can have a similar impact initially, although a stabilization of monetary policy might create a reversal of that division between real growth and deflation.

Other economic policies and trends that impact productivity and economic incentive can also impact the real growth rate and inflation without any change in monetary policy. For example something like Katrina would be expected to lower real growth as production is disrupted and increase inflation for the same reason.

Roger Arnold Replies:

The mechanisms you offer for open market operations are in deed those followed both by Volker and by Greenspan; namely using the fed funds target rate to indirectly manipulate money supply. However, and I may be wrong, but I do not believe there is anything in the feds mandate that requires it to manipulate the potential for fed created money supply by way of the fed funds target rate. In other words there is no direct, hard, non-elastic relationship between money supply and the fed funds target rate, only that this has been the feds chosen procedure and mechanism. The fed can target the supply of money directly, independently of the fed funds target rate. The real question then is not can they do so but can they do so with seemingly opposing goals; i.e. increase the money supply directly while simultaneously increasing the fed funds target rate. But, if that proves to be not viable the fed can also alter reserve requirements; i.e. monetize the issuance of new federal debt while simultaneously increasing reserve requirements at the banks receiving the reserves. Thereby ensuring that the federal government gets the money but the banks are left marginally without the ability to make new private loans except to those borrowers with the highest credit quality, chiefly large supra-nationals carrying risks similar to the federal government. So, the supply of money has been increased but the availability of this money to the private economy has not, only to the federal government and big business. And this exercise in figuring out how the fed can both monetize the federal debt and maintain an inflation target is almost endless. The question is not can it be done but how will it be done and will the markets tolerate it. The ramifications of attempting to do what Bernanke has indicated he will do are enormous. So, is Bernanke lying when he says he will monetize the debt, and once in office refuse to do so? Or, will he attempt to monetize the debt while maintaining an inflation target? Or, will he shift toward an inflation target exclusively and oppose monetizing the debt as is the case at the ECB? Whatever he chooses to do is going to leave some people not happy because you can't appease the federal government, the banks, and the public simultaneously. In trying to determine what is most likely requires understanding what Bernanke thinks the role of a central bank is and more importantly who he believes the US fed is most beholden to. Is it the fed and member banks and the value of their reserves? Is it the federal government? Is it the public? Or is it the globalists; i.e. the fed member banks primary clients, the large supranationals? These same have already co-opted fiscal policy. Are they now, with Bernanke at the head attempting to co-opt monetary policy? I don't know the answer but believe we will get an indication from Bernanke sooner than most think.

I have not followed Bernanke's pronouncements so I do not know what he will do or what exactly he has proposed to do with regard to monetary debt. The last time the Fed tried to accommodate the Treasury debt as its main objective was in WWII and its aftermath. That did not work out well and the practice was ended with an accord in the early 1950 s that ended this practice and established the independence of the Fed from Treasury needs. That earlier practice is not likely to be reinstituted; the financial markets and foreign investors in the dollar would not take it well, and it would mean the U.S. effort to contain inflation is over unless fiscal policy was very prudent.

Rudolf Hauser Responds:

No, Roger, it does not work the way you suggest. You could buy Treasuries in open market operations and raise reserve requirements to offset it. But then you would not increase the money supply. The interest rate is set with respect to the overall credit markets supply/demand situation. If private credit demands were strong relative to available savings, rates would rise irrespective if the Fed does what you suggest or if the Treasury tried to sell the securities without any change in Fed policy if high-powered money and money supply remained unaffected. If private demands were weak relative to savings, neither would have much impact on rates, as has so often been the case. At most such an operation might shift the relation between the rates on Treasuries and other securities. If the Fed raises reserve requirements more banks will need more reserves. That will offset the increase in reserves from the open market operations. If the former is larger in its impact than the latter, the Fed funds rate will increase. It is a simple matter of supply and demand. The only way this would work is to use something other than the interest rate to restrict borrowing or increase savings.

No there is no hard fixed relationship of the Fed funds rate to money supply. Many factors influence money, depending on the definition of money used. Money is a theoretical concept, and any given measure is only a proxy for that concept. Different assets had different degrees of moneyness and some might be outside the banking system and currency. There are currently no reserve requirements against M2-M1, making Fed direct control of M2 possibly more difficult. What matters is the difference between the Fed s targeted Fed funds rate and the natural market rate. The latter changes all the time, and the amount of reserves needed to close the gap is not a constant either. On another point, if the Fed were to target money supply correctly, it would have no control over the Fed funds rate as the only way it has any control over the latter is by increasing or contacting high-powered money. The Fed could announce a Fed funds target which might have a temporary effect but under such a system such an announced target would soon lose all credibility as it would not be enforced. But as I pointed out before while the short-term impact of an easy monetary policy is to lower short-term rates, the impact as the economy and inflation speeds up is for higher nominal rates. The risk premium might also go up on real rates, although that might be viewed as part of the inflation premium since the risk is mainly that of future inflation. So eventually you would have your higher Fed funds rate of Roger's suggestion but that is because the policy followed was inflationary.

Jeff Rollert Replies:

In response to George Zachar:

Bernanke will likely, after a decent interval, try to move the Fed culture away from discretionary opaque Greenspanism toward explicit rules/targets.

Bernanke doesn't understand that by being clear he will lose his ability to maneuver...thus whatever his "system" is/was/will be will then be run over roughshod by the Street and their many contacts within the Fed's revolving hotel. He will tell folks that the emperor has no clothes on... Bush doesn't see this.

Mark Mahorney Responds:

I'm sure he's already well aware of this. If not he will be coached. If he still doesn't get it he'll take a beating first time out. Then he'll get it. People are overanalyzing and projecting their own inability to learn from their mistakes onto Bernanke.

Rudolf Hauser responds again

Let me deal with a whole number of points Roger has raised. With regard to my general views, let me start with a brief discussion of the role of monetary policy as I see it. Money serves a number of purposes. For one it is as both a standard of exchange and a medium of exchange. For humanity to prosper it must be able to use man s creative genius to innovate and specialize. The division of labor and ability to trade is essential for moving mankind much beyond the subsistence level in most geographic locations. The use of barter is rather inefficient in that task. It is facilitated by a durable, light easily transportable, inexpensive representation of value that is widely accepted in trade as a representation of value because it will be excepted widely in trade. It is dependent on the trust that it will be honored widely and retain its fair value over both distance and time.  It may or may not have value outside its function as money, but to be efficient in that function it should have a value as money above that of what it would be worth as a simple commodity.  In order to have and retain value it is important that it difficult to counterfeit. It is also important that its supply be limited relative to goods and services traded so that it retains its value over time. The latter allows the extension of credit that will be repaid in the future with a hoped for return and to save for the future in a form other than physical commodities. It means that direct ownership in the means of production will not be the only way to save. By allowing all goods and services to be expressed in terms of one item, it allows one price to be established which will be understandable to everyone and in doing so allows the transmission of information that is vital for the most efficient use of resources in production. Were it not so one would have to think in terms of thousands upon thousands of cross reciprocal relationships and the costs of finding what one wanted and trading it for something one had to offer, with possibly many intermediate trades of unwanted goods in the process. Money would serve that function in part even if it were imaginary. That is, if everything were quoted in terms of a non-existent currency, it would still allow a value to be set on individual commodities and services in a common means that would facilitate barter trade in items intended for future exchange to obtain what one really wanted and of which one would otherwise find difficult to value in trade. Having actual money eliminates the need for such wasteful barter.

But while money facilitates economic growth it does little beyond that if it is an efficient as it can be in its own function. It disrupts that maximum potential that would otherwise exist if it does not perform its function well. Real growth ultimately depends on such factors as innovative genius, the freedom to exercise one  s own will to achieve one s own ends, peace, the amount that people are willing to save, the risks people are willing to take, the role of envy in the culture, the skill people have in investing time and resources in areas most valued, the trust people have in each other s honesty and willingness to honor long-term contracts, government s role, levels of taxation, etc. This area is a whole separate area of discussion that gets us away from the role of money. What the supply of money relative to its demand does determine is the value of money relative to the goods and services it commands, that is it determines the price level measured in money terms and change therein measure inflation. Because the individual producer and consumer obtains his or her information from prices that tell them whether their activity is likely to be profitable or not and changes in prices provides information of the value of the items or services in relative terms, overall changes in the price level, which only translate into individual prices over time, might be mistaken for such real changes and result in erroneous production and consumption decisions. Such errors result in inefficient allocation of resources and contribute to business losses and failures. Hence unexpected changes in inflation disrupt real economic activity. Likewise, great uncertainty over the future inflation outlook discourages long-term commitments and thereby retards economic growth prospects. These are examples of the negative impact of money when it is not efficient as it should be. Good monetary policy cannot add to real economic growth beyond what is possible with an efficient monetary system but a move to a good monetary policy from a bad monetary policy can reduce the harm to economic growth that was caused by the latter.

Good monetary policy is complicated in that the demand for money changes over time both because of real economic growth, increased levels of commerce and finance (transactions) and changes in the demand for money relative to income and transactions. Money provides an additional function in that it offers liquidity, namely the ability to purchase or pay quickly and without the loss entailed in selling an item for which the market is more limited and the introduction of sudden supply might bring down the price because ready buyers cannot be quickly found who would pay a given price if knowledge were everywhere perfect and transactions not hindered by delays of communication and transportation and costs thereof. This important function of money is served by various instruments in addition to currency and checking accounts to various degrees and subject to market innovation. Actual money is held to provide such liquidity, and the demands for such will be influenced by such factors as the opportunity and actual costs of holding money, the level of uncertainty, risk preferences, concerns about inflation, etc. that can result in changes in income velocity. Major swings in money dwarf likely contrary changes in velocity. Major expansions in money increase the inflation risk and thereby reduce the demand for money, so that velocity in such cases would increase, compounding the inflationary impact of monetary expansion. A reversal of that situation has the opposite effect. But more modest changes in monetary growth could be small relative to changes in opposing changes in velocity resulting from various market forces. Contractions in money or slower than expected growth therein can result in insufficient liquidity, just as and expansion can result in more liquidity than people need. When one has excess liquidity one either feels free to buy more for consumption or to invest it in less liquid, riskier and higher returning assets. When liquidity is deemed insufficient, one tries to increase it by curtailing spending and by selling other assets, bringing about an economic downturn if all the adjustment does not take place in prices.

At one time, man felt most comfortable in using a commodity money standard as the commodity had some value in and of itself. A rare commodity such as gold had the additional value of being limited in production and hence more likely to retain its value over time. The disadvantages of carrying around such a heavy commodity lead to the development of banking and the use of paper currency and checking backed by that physical commodity. A system of partial backing soon became acceptable. But even such a gold standard has its disadvantages. Money as such, like all goods, should be produced as cheaply as is necessary to maximize human productive capacity on useful things. Gold mining is quite expensive relative to the creation of a paper currency. In addition, its supply is dependent on finding natural resources and increases in technology that enable more to be produced from available raw supplies. It also is dependent on other uses for that commodity that might compete with its monetary function. In all these respects a centrally managed fiat currency would be preferable if it would be managed well. There is no way to insure that. (I will not discuss the issue of free banking here nor the role of a gold standard vs. a fist standard on international transactions as this post is getting to be too long already.)

A fixed level of money is not desirable because it would result in deflation, which is harmful to economic growth because it creates too high a real interest rate. One always has the alternative of holding cash, so that the nominal interest rate for practical purposes cannot go below zero. With deflation, the difference between the rate of deflation and zero is the minimum real interest rate possible (ignoring a few minor quirks). So high rates of deflation create very high real rates that discourage investment. To avoid problems of monetary discretion that have often resulted in inflationary and/or disruptive policies that have made economic conditions worse, Milton Friedman long advocated a constant growth rate for money at a rate consistent with the increasing need for money because of real non-inflationary growth in the economy. For a long time I agreed with that view. But with all the disruptions we have had, new financial innovation, etc. I am no longer convinced that is the best approach as evidenced by the changes in velocity we have seen. Since the main function of a proper monetary policy is to have a stable price level or one that at most rises or falls at a very modest predictable rate, setting a policy rule in terms of inflation in a forward looking sense to take into account the lags from money creation to its impact on the price level makes much sense and in the long-run is a policy consistent with the most monetary policy can contribute to real growth. New instruments and better understanding of finance make it easier to take such a forward looking approach. That is not to say that shocks to the system such as 9/11 might not create sudden changes in the demand for liquidity that the Fed should temporarily accommodate to prevent disruptions to the economy, but that over time it should not deviate from its stable (and low or zero) inflation goal. Too often in the past Fed efforts to deal with events that already occurred resulted in policies that actually make conditions worse. In the view of some, Greenspan has done a good job in anticipating some of these other influences and creating a better monetary policy relying on more discretion. Others on this list disagree, but often his discretion has resulted in deviations from what a fixed policy rule would have called for that those who disagree feel should have been far greater than they were (and in the same direction) so that they would likely be unhappy with a fixed rule policy also. But having a fixed inflationary rule would reduce the possibility that some future less competent chairman and FOMC would really make things much worse as happened in the 1970 s and 1930 s. A formal as opposed to informal move to an inflation target rule would require legislative change in the Fed s congressional mandate.

As to some of Rogers  points:  And as the FOMC is only an advisory institution to the fed chair and not a democratic body we are left having to rely on Ben Bernanke and his black box; ala the Wizard of Oz.

The FOMC determines open market policy, either by setting a Fed funds target or some other instructions to those on the open market desk. It is a voting body, and the chairman only has one vote like anyone else. He has some power in his role as chairman that can influence the vote of others but in the end his main power is that of his ability to intellectually dominate the rest of the board or engage in clever politics combined with economic reasoning to get a majority vote. The FOMC is not just an advisory body. Borrowing rates and other banking policy are set by the Board of Governors, but all the Governors, including the chairman, only have one vote apiece. The only exclusive power the chairman has is in his executive function set within the limits of the law and those policy decisions by the board and FOMC. That is not to say that powerful chairman such as Greenspan have not often had a dominant influence.

Roger writes:  Nonetheless, it would seem prudent for anyone trying anticipate his future proclivities in guiding fed policy to try to resolve how he is going to go about attainting a long run average US inflation rate of 2% within an economic system that has no savings, sovereign debt to GDP approaching 7% [Much higher than that-RH] and rising, without sacrificing something; i.e. the dual mandate disappears, or there is a forced shift in resources from the private sector to the public one.

For the world, consumption plus savings is equal to production. We cannot save or consume more than we produce except when we borrow from abroad.  If the government wishes to spend it must either tax or borrow. We are talking real resources here for that is all that really matters. When it borrows it takes a claim to production away from the private sector. The creation of money is no more than paper (and that uses up a small amount of productive capacity, including the people involved in the process.) Monetary creation reduces the value of money. The seller of those government securities (either directly or the person who gave the Treasury his claim on real resources and is now selling the security to the Fed) can spend the money for real goods and services only because existing holders of money can now buy less goods and services than before for the same amount of money. That is the inflation tax. In addition all debtors benefit from this relative to their lenders if the resulting inflation was not taken into consideration when the contract was made. One way or the other what the government spends can only come out resources from the private sector.

Roger writes:  And there is warrant at the margin in that contention as the fed banks are under no legal obligation to abide by the fed funds target.

The fed funds target is an instruction to the open market desk at the New York Fed. This is the only part of the Fed system that engages in open market transactions. The Fed funds target, unlike reserve borrowing rates has no direct relevance to any of the other regional Fed district banks. If the open market desk is given both a Fed funds target and a target to buy a set amount of government securities, or create a set amount of money or reserves it will have conflicting targets. One cannot go both right and left at the same time. A choice has to be made. In this case there may be times when the two goals coincide and others when they do not. Then the question is which instruction will be followed and which ignored.

Roger writes:  The feds symbolic discount window may very well in practice displace the fed funds target rate. Or, in a worst case scenario, would cause congress to re-write the mandate all together; i.e. essentially nationalize the fed.

If reserves are insufficient then if the Fed funds rate gets too high, banks will turn to the discount window. Then the willingness of the Fed to lend comes into play. The new policy that has not had much of an effect in practice so far is to provide funds more freely, but that policy could easily be changed if the Fed desires to do so. The issue of open market operations and the relation to borrowing by banks was discussed before. The private ownership of the district Fed banks is without much significance. For practical purposes the Fed is a government institution already. It is only a question as to whether immediate monetary policy will be set by the Treasury or a somewhat independent Fed Reserve Board and FOMC. In all cases there is the knowledge that the Congress at any time could attempt to change the rules, giving both the President and the Congress some indirect power over Fed action. It has been observed that when a President really cared about Fed policy, the policy was usually largely accommodated to his desires.