The Fed: Managing Expectations

-- Posted Friday, 25 July 2003 | Digg This Article Digg It!

July 25: Since the inflation crisis of the 1970s, the Federal Reserve has consistently pursued the goal of price stability in the United States. And not too long ago, something remarkable happened--the goal was achieved! - Ben Bernanke

One of Aristotle's maxims, that it is the mark of an educated mind to be able to entertain an idea without accepting it, kept popping into my head while listening to "talk radio" during my 6 hours in the car yesterday. Adamantine positions were taken on a variety of generalized issues; to wit, American jurors take their job seriously and are fair, the Iraqis are celebrating the death of Saddam's sons, etc. Counter-claim rebuttals tended to inspire ad hominem attacks rather than any softening of position. The Jamesian notion of reshuffling prejudices as proxy for thinking was quite apparent which inspired me to ponder the risks inherent in manipulating conventional epistemology.

	US Economic Calendar	EST
Mon	LEI	10:00
Tues

Wed

Thurs
Fri	Durables	8:30
	Ex, New Homes Sales	10:00

	@ 9:45AM	% chg
Gold	363	0.28%
Euro	1.15	0.26%
$/Jpy	118.8	-0.17%
USDX	95.06	-0.29%
US 10 Yr	4.16
3M Libor	1.11
DJ Stoxx 50	2416	-0.86%
N225	9648	-0.24%
Oil	30.04	-0.60%

As Plato's decision to include his analogy of the cave in The Republic suggests, the concern over a fraudulent conventional wisdom has been an issue for man for millennia. In a sense, the freedoms of religion and speech enshrined in the Bill of Rights, are attempts to avoid the outcome of Plato's cave full of shadow masters. Yet, it seems to me that the issue is not that the few see for the many, but rather that, knowing this, the few assert views which are false.

Taking a real world example, the "taking up" of serpents as proof of faith in God, we see that people can come to believe many strange things. Recalling the old tests for being a witch, those who get bitten by snakes during these sessions are


shunned as "unworthy of God," not as counterfactual evidence that poisonous snakes are best left unhandled. I bring the practice to your attention, and yes it is still practiced, to illustrate how, using the proper ideological levers, on in Jungian terms, archetypes, people can be manipulated even when the article of faith in question runs counter to their "common sense." Some people, upon reading this, might sneer at such behavior as silly and not something they would do at all. However, how many people in the late 90s believed that the stock market was going to keep rising in perpetuity, a belief that has caused the faithful a great deal of pain. How many more feel that the price of their house couldn't fall, or couldn't imagine that the US$ might someday be worthless. We laugh at the notion of blood letting yet, apparently, think health insurance, rather than healthy lifestyles, will better ensure a healthy life. Who knows which ideas, now accepted as true, will be seen as silly, decades from now. One such notion, at least as I view the world, that the Federal Reserve's elastic money policies engender a better economic environment than that which flows from specie standards lies at the core of my financial outlook. That is, I believe the fiat money faithful are, in a sense, like the advocates of snake handlers, preaching a hurtful doctrine. Moreover, I believe this faith is now so strong that only a fairly widespread counterfactual, like a global economic depression will lead people to a different view. It was with this frame of mind that I read Fed Governor Bernanke's recent speech, An Unwelcome fall in inflation?, from which emerged this morning's quote. I wonder if Mr. Bernanke would tell a friend to keep smoking two packs of cigarettes a days because he had not yet experienced lung problems. That is, why should we universalize the current apparent low level of inflation and conclude that the Fed has, in his words, achieved its goal. I surmise, from the recent bond market collapse, that the market does not see the same world that Mr. Bernanke sees. Indeed, this speech is an attempt to correct market misinterpretation of Fed views. In his words, Some in the media apparently interpreted the May 6 statement as saying that the Federal Reserve anticipated imminent deflation in the United States and informed the public accordingly. In my view, such an interpretation substantially overstates the concerns that the FOMC intended to communicate with its statement.		Why, I wonder, if the Fed was not, as Bernanake asserts, particularly worried about deflation, did they not cry foul when the bond market was soaring? Talk of "unconventional measures" to fight deflation was all the rage as bond yields plummeted in June. It is only after bond portfolios took the loss that the Fed feels the need to step up to the bully pulpit with their hands in the air saying, in a sense, I don't know where you bond traders got the idea that we were worried about deflation. Perhaps, Mr. Bernanke, this notion, in part, flowed from your 2002 speech, Deflation: Making sure it doesn't happen here, wherein you asserted that the second main reason the US would avoid deflation was the ability of the Fed to produce as many U.S. dollars as it wishes at essentially no cost. Moving past the Fed's words, lets look at their deeds. Do the reported manifestations of Fed policy, of which I favor the monetary base, suggest a concern with deflation? In my view, no. Despite a substantial decline in the annual growth rate of broad money, the annual growth rate of the monetary base, which the Fed controls, is far less than that seen in the run-up to Y2K or in the aftermath of the 9/11 attacks. As today's chart makes clear, the current growth rate of the monetary base is at the low end of its range over the past 3 decades. Indeed, it seems to me from looking at the charts as if the Fed was trying to wring inflation from the system, not prevent deflation. This in turn leads me to speculate that the Fed was perhaps using the bully pulpit to "talk up" deflation as part of its inflation fighting scenario. Thus today's theme, the dangers of manipulating conventional wisdom. As the old fable of the boy who cried wolf intends to teach, once caught in a lie, credibility becomes elusive. Using Aristotle's definition, a liar is one who, when telling the truth, is not believed. It seems to me that the Fed is walking a tightrope and has lost its balance. Absent a hard money standard, deflation seems an extremely low probability event in the US. If the bond market begins to see that the Great and Powerful Fed (Oz) is really just a little man behind a curtain manipulating them, things could quickly get out of control. Thus, I believe, the rather high option premiums for bond puts as well as the rising price of Gold these days. Perhaps the Fed can regain the market's trust and keep this bubble inflated for awhile longer yet. However, given the rising tide of skepticism always engendered during war time, and substantial bond portfolio losses, I think the Fed will have a tough time repairing its halo.


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