Road to Hyperinflation is paved with Market Accommodating Monetary Policy

Henry C.K. Liu

Part I: A Crisis the Fed Helped to Create but Helpless to Cure

Part II: Central Banking History of Failing to Stabilize Markets

This article appeared in AToL on January 30, 2008

It has been forgotten by many that before 1913, there was no central bank in the United States to bail out troubled commercial and associated financial institutions or to keep inflation in check by trading employment for price stability. Few want inflation but fewer still would trade their jobs for price stability.

For the first 137 years of its history, the US did not have a central bank. The nation then was plagued with recurring business cycles of boom and bust. For the past 94 years that the Federal Reserve, the US central bank, has assumed the role of monetary guardian for the nation, recurring business cycles of boom and bust have continued, often with the accommodating participation of the Fed. Central banking has failed in its fundamental functions of stabilizing financial markets with monetary policy, succeeding neither in preventing inflation nor sustaining growth nor achieving full employment. Since the Fed's founding in 1913, US inflation has registered 1,923%, meaning prices have gone up 20 times on average despite a sharp rise in productivity.

For the 18 years (August 11, 1987 to January 31, 2006) of his tenure as chairman of the Fed, Alan Greenspan had repeatedly bought off the collapse of one debt bubble with a bigger debt bubble. During that time, inflation was under 2% in only two years, 1998 and 2002, both times not caused by Fed policy. Paul Volcker, who served as Fed Chairman from August 1979 to August 1987, had to raise both the fed funds rate and the discount to 20% to fight hyperinflation of 18% in 1980 back down to 3.66% in 1987, the year Greenspan took over the Fed just before the October 1987 crash when inflation rose to 4.53%.

Under Greenspan’s market accommodating monetary policy, US inflation reached 4.42% in 1988, 5.36% in 1989 and 6.29% in 1990. US inflation rate was moderated to 1.55% by the 1997 Asian financial crisis when Asian exporting economies devalued their currencies to lower their export prices, but Greenspan allowed US inflation rate to rise back to 3.76% by 2000.  The fed funds rate hit a low of 1.75% in 2001 when inflation hit 3.76%; it hit 1% when inflation hit 3.52% in 2004; and it hit 2.5% when inflation hit 4.69% in 3005. For those years, US real interest rate was mostly negative after inflation. Factoring in the falling exchange value of the dollar, the Fed was in effect paying US transnational corporate borrowers to invest in non-dollar markets, and paying US financial institution to profit from dollar carry trade, i.e. borrowing dollars at negative rates to speculate in assets denominated in other currencies with high yields.

Central Banks Prevent Global Market Corrections with Hyperinflation

In recent years, the US has been allowing the dollar to fall in exchange value to moderate the adverse effect of high indebtedness and use depressed wages, both domestic and foreign, to moderate US inflationary pressure. This trend is not sustainable because other governments will intervene in the foreign exchange market to keep their own currencies from appreciating against the dollar to remain competitive in global trade. The net result will be a moderating of drastic changes in the exchange rate regime but not a halt of dollar depreciation.  What has happened is a global devaluation of all currencies with the dollar as the lead sinking anchor in terms of purchasing power. The sharp rise of prices for assets and commodities around the world has been caused by the sinking of the purchasing power of all currencies. This is a trend that will end in hyperinflation while the exchange rate regime remains operational, particularly if central banks continue to follow a coordinated policy of holding up inflated asset and commodities prices globally with loose monetary policies, i.e. releasing more liquidity every time markets face imminent corrections.

Politics of Central Banking

The circumstances that created the political climate in the United States for the adoption of a central bank came ironically from internecine war on Wall Street that spread economic devastation across the nation during the recession of 1907-08, the direct result of one dominant money trust trying to cannibalize its competition.

In 1906, the powerful Rockefeller interests in Amalgamated Copper executed a plan to destroy the Heinze combination, which owned Union Copper Co. By manipulating the stock market, the Rockefeller faction drove down Heinze stock in Union Copper from $60 to $10. The rumor was then spread that not only Heinze Copper but also the Heinze banks were folding under Rockefeller pressure. J P Morgan joined the Rockefeller enclave to announce that he thought the Knickerbocker Trust Co would be the first Heinze bank to fail. Panicked depositors stormed the teller cages of Knickerbocker to withdraw their money. Within a few days the bank was forced to close its doors. Similar fear spread to other Heinze banks and then to the whole banking world. The crash of 1907 was on.

Millions of depositors were sold out penniless their savings wiped out by bank failures and homeowners rendered homeless by bank foreclosure of their mortgages. The destitute, the hungry and the homeless were let to fend for themselves as best they could, which was not very well. Money still in circulation was hoarded by those who happened to still have some, so before long a viable medium of exchange became practically non-existent in a dire liquidity crisis. The 1907 depression was much severe for the average family than the one in 1930.

Many otherwise healthy businesses began printing private IOUs and exchanging them for raw materials as well as giving them to their remaining workers for wages. These “tokens” passed around as a temporary medium of exchange to keep the economy functioning minimally. At this critical juncture, J P Morgan offered to salvage the last operating Heinze bank (Trust Co of America) on condition of a fire sale of the valuable Tennessee Coal and Iron Co in Birmingham to add to the monopolistic US Steel Co, which he had earlier purchased from Andrew Carnegie.

This arrangement violated then existing anti-trust laws but in the prevailing climate of depression crisis, the proposed transaction was quickly approved by a thankful Washington. Morgan was also intrigued by the paper IOUs that various business houses were being allowed to circulate as temporary media of exchange. Using the argument of the need to create order out of monetary chaos, the same argument that Rockefeller used to build the Standard Oil Trust, Morgan persuaded Congress to let him put out $200 million in such “tokens” issued by one of the Morgan financial entities, claiming this flow of Morgan “certificates” would revive the stalled economy. The nominal GDP fell from $34 billion in 1907 to $30 billion in 1908 and did not recover to $34 billion until 1911, even with an average annual inflation rate of over 7%.

Getting Rich from Making Money

As these new forms of Morgan “money” began circulating, the public regained its “confidence” and hoarded money began to circulate again as well in anticipation of inflation. Morgan circulated $200 million in “certificates” created out of nothing more than his “corporate credit” with formal government approval. This is the equivalent of $100 billion in today’s money. It was a superb device to get fabulously rich by literally making money.

Eight decades later, GE Capital, the finance unit of the world’s largest conglomerate that incidentally also manufactures hard goods, did the same thing in the 1990s with commercial papers and derivatives to create hundreds of billions in profits. Soon, every corporation and financial entities followed suit and the commercial paper market became a critical component of the financial system. This was the market that seized in August 2007 that started the current credit crisis. “The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,” said William H. Gross, chief investment officer of the bond management firm Pacific Investment Management Company, known as Pimco.

The commercial paper market historically was best known as an alternative market funding source for non-financial corporations, at times when bank loans were seen as too expensive or possibly not available due to tight monetary policy. Finance companies, especially those affiliated with major auto companies and well-known consumer-credit lenders have also issued paper tied to non-financial industrial entities.  In the mid-1990s, non-financial corporate issues were still nearly 30% of total paper outstanding.  This share began to drop precipitously just before the recession of 2001 and has stabilized but not recovered.  By March 2006, the non-financial segment constituted a mere 7.8% of the total, the lowest ever in the 37-year history of the data. Financial companies have also altered their approach to the market.  Some paper is still backed by companies’ general financial resources, but other commercial paper is backed by specific loans, including automobile and credit card debt and home mortgages. Most ominously, commercial paper is used to finance securitized credit instruments that move debt liabilities off the balance sheets of the borrowers.

Some conspiracy theorists assert that the seeds for the Federal Reserve System had been sown with the Morgan certificates. On the surface, J P Morgan seemed to have saved the economy - like first throwing a child into the river and then being lionized for saving him with a rope that only he was allowed to own, as some of his critics said. On the other hand, Woodrow Wilson wrote: “All this trouble [the 1907 depression] could be averted if we appointed a committee of six or seven public-spirited men like J P Morgan to handle the affairs of our country.” Both Morgan and Wilson were elite internationalists.

The House of Morgan then held the power of deciding which banks should survive and which ones should fail and, by extension, deciding which sector of the economy should prosper and which should shrink. The same power today belongs to the Fed whose policies have favored the financial sector at the expense of the industrial sector. At least the House of Morgan then used private money for its predatory schemes of controlling the money supply for its own narrow benefit. The Fed now uses public money to bail out the private banks that own the central bank in the name of preventing market failure.

The issue of centralized private banking was part of the Sectional Conflict of the 1800s between America’s industrial North and the agricultural South that eventually led to the Civil War. The South opposed a centralized private banking system that would be controlled by Northeastern financial interests, protective tariffs to help struggling Northeast industries and federal aid to transportation development for opening up the Midwest and the West for investment intermediated through Northeastern money trusts backed by European capital.

Money as Political Instrument

Money, classical economics’ view of it notwithstanding, is not neutral. Money is a political issue. It is a matter of deliberate choice made by the state with consequential implications in support of a strategic political and geopolitical agenda. In a democracy, that choice should be made by the popular will, rather than by a small select group of political appointees. The supply of money and its cost, as well as the allocation of credit, have direct socio-political implications beyond finance and economics. Policies on money reward or punish different segments of the population, stimulate or restrain different economic sectors and activities. They affect the distribution of political power. Democracy itself depends on a populist monetary policy.

Economist Joseph A Schumpeter (1883-1950) observed that in the first part of the 19th century, mainstream economists believed in the merit of a privately provided and competitively supplied currency. Adam Smith differed from David Hume in advocating state non-intervention in the supply of money. Smith, an early advocate of progressive taxation, argued that a convertible paper money could not be issued to excess by privately owned banks in a competitive banking environment, under which the Quantity Theory of Money is a mere fantasy and the Real Bills doctrine was reality. Smith never acknowledged or understood the business cycle of boom and bust. He denied its existence by proposing to forbid its emergence by the use of governmental powers. The policy of laissez-faire, or government non-intervention in trade, broadly attributed by present-day market fundamentalists to Adam Smith who himself never used the term, nor did any of his British colleagues, such as Thomas Malthus and David Ricardo, requires government intervention to be operative.

The anti-monopolistic and anti-regulatory Free Banking School found support in agrarian and proletarian mistrust of big banks and paper money. This mistrust was reinforced by evidence of widespread fraud in the banking system, which appeared proportional to the size of the institution. Paper money was increasingly viewed as a tool used by unconscionable employers and greedy financiers to trick working men and farmers out of what was due to them in a free market. A similar attitude of distrust is currently on the rise as a result of massive and pervasive corporate and financial fraud in the brave new world of banking fueled by structured finance in the under-regulated financial markets of the 1990s, though not focused on paper money as such, but on electronic money use in derivative transactions, which is paperless virtue money built on debt.

The $7 billion loss cause by alleged fraud committed by a low-level trader at Société Générale, one of the largest and most respected banks in France, was shocking not because it happened, but because for a whole year, the fraud was not discovered while the unauthorized trades were profitable. It would not be unreasonable for the counterparties that had suffered losses in these unauthorized but profitable trades to sue SoGen for recovery.

Andrew Jackson who in 1835, managed to reduce the federal debt to only $33,733, the lowest it has been since the first fiscal year of 1791, vetoed the bill to renew the charter of the Second Bank of the United States. In his farewell speech in 1837, Jackson addressed the paper-money system and its natural association with monopoly and special privilege, the way Dwight D Eisenhower in 1961 warned a paranoid nation gripped by Cold War fears against the domestic threat of a military-industrial complex at home. The value of paper, Jackson stated, “is liable to great and sudden fluctuations and cannot be relied upon to keep the medium of exchange uniform in amount.”

In his veto message, Jackson said the Bank needed to be abolished because it concentrated excessive financial strength in one single institution, exposed the government to control by foreign investors, served mainly to make the rich richer and exercised undue control over Congress. “It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes,” wrote Jackson.  In 1836, Jackson issued the Specie Circular which required government lands to be paid in “specie” (gold or silver coins), which caused many banks that did not have enough specie to exchange for their notes to fail, leading to the Panic of 1837 as the bursting of the speculative bubble threw the economy into deep depression. Jacksonian Democrat partisans to this day blame the severe depression on bank irresponsibility, both in funding rampant speculation and by abusing paper money issuance to cause inflation. It remains to be seen if the credit crisis of 2007 would cause the elections of 2008 to revive the Jacksonian populism that founded the modern Democrat Party.

’s farewell message read: “....The planter, the farmer, the mechanic, and the laborer all know that their success depends upon their own industry and economy and that they must not expect to become suddenly rich by the fruits of their toil. Yet these classes of society form the great body of the people of the United States; they are the bone and sinew of the country; men who love liberty and desire nothing but equal rights and equal laws and who, moreover, hold the great mass of our national wealth, although it is distributed in moderate amounts among the millions of freemen who possess it. But, with overwhelming numbers and wealth on their side, they are in constant danger of losing their fair influence in the government, and with difficulty maintain their just rights against the incessant efforts daily made to encroach upon them.”

It is clear that the developing pains of the credit crisis of 2007 is not evenly borne by all, with a select few who had caused the crisis walking away with million in severance compensation and the few who are selected to restructure the financial mess no doubt will gain millions while the mass of victims are losing homes, jobs and pensions, with no end in sight. The trouble with unregulated finance capitalism is not just that it inevitably produces boom and busts, but that the gains and pains are distributed in obscene uneven proportions.

Merit of Central Banking Overstated

The monetary expansion that preceded and led to the recession of 1834-37 did not come from a falling bank reserve ratio, but rather from the bubble effect of an inflow of silver into the United States in the early 1830s, the result of increased silver production in Mexico, and also from an increase in British investment in the United States. Thus a case could be made that the power of central banking in causing or preventing recessions through management of the money supply is overstated and oversimplified.

Libertarians hold the view that the state had neither the right nor the skill to regulate any commercial transactions freely entered into between consenting individuals, including the acceptance of paper currency. Thus all legal tenders, specie or not, are government intrusions. Yet the key words are “freely entered into”, a condition most markets do not make available to all participants. Market conditions invariably compel participants to enter into disadvantaged transactions for lack alternatives because of uneven market power.

For example, family must buy food regardless of price set by agribusiness, since inflation is not a matter that the average consumer can control.  When it comes to money, a medium of exchange based on bank liabilities and a fractional reserve system and/or government taxing capacity is essential to an industrializing economy. But today, when bank liability can be masked by off-balance sheet securitization, the credibility of money is threatened. Back in 1837, instead of eliminating abuse of the fractional reserve system, the hard-money advocates had merely unwittingly removed a force that acted to restrain it.

After 1837, the reserve ratio of the banking system was much higher than it had been during the period of the Second Bank of the United State (BUS2). This reflected public mistrust of banks in the wake of the panic of 1837 when out of 850 banks in the United States, 343 closed entirely, 62 failed partially. This lack of confidence in the paper-money system led to the myth that it could have been ameliorated by central-bank liquidity, which would have required a lower reserve ratio, more availability of credit and an increase of money supply during the 1840s and 1850s. The myth contends that with central banking, the evolution of the US banking system would have been less localized and fragmented in a way inconsistent with large industrialized economics, and the US economy would have been less dependent on foreign investment. This did not happen until 1913 because central banking was genetically disposed to favor the center against the periphery, which conflicted with democratic politics.

President Martin Van Buren was harshly judged and lost reelection because of his ideologically commitment of keeping the government out of banking regulation. Many economic historians feel Van Buren extended the effects of the Panic which lasted until 1843, while others consider his approach to have minimized potentially destructive interference.

This problem continues today with central banking in a globalized international finance architecture. It remains a truism that it is preferable to be self-employed poor than to be working poor. Thus economic centralism will be tolerated politically only if it can deliver wealth away from the center to the periphery to enhance economic democracy. Yet central banking in the past two decades has centralized wealth. Central banking carries with it an institutional bias against economic nationalism or regionalism as well as a structural bias in favor of economic centralism. It obstructs the delivery of wealth created at the periphery back to the periphery.

After 1837, the US federal government had no further connection with the banking industry until the National Bank Act of 1863. Although the Independent Treasury that operated between 1846 and 1921, to pay out its own funds in specie money and be completely independent of the banking and financial system of the nation, did restrict reckless speculative expansion of credit, it also created a new set of economic problems. In periods of prosperity, revenue surpluses accumulated in the Treasury, reducing hard-money circulation, tightening credit, and restraining even legitimate expansion of trade and production. In periods of depression and panic, on the other hand, when banks suspended specie payments and hard money was hoarded, the government's insistence on being paid in specie tended to aggravate economic difficulties by limiting the amount of specie available for private credit. The Panic of 1907 exposed the inability of the Independent Treasury to stabilize the money market and led to the passage of the Federal Reserve Act in 1913, which allowed the Federal Reserve Bank, a private corporation, to coin money and regulate the value of the common currency.

The Right to Make Money Taken From the People

The 1863 US National Bank Act amended and expanded the provisions of the Currency Act of the previous year. Any group of five or more persons with no criminal record was allowed to set up a bank, subject to certain minimum capital requirements. As these banks were authorized by the federal government, not the states, they are known as national banks, not to be confused with a national bank in the Hamiltonian sense. To secure the privilege of note issue they had to buy government bonds and deposit them with the comptroller of the currency.

When the Civil War began in 1861, newly installed President Abraham Lincoln, finding the Independent Treasury empty and payments in gold having to be suspended, appealed to the state-chartered private banks for loans to pay for supplies needed to mobilize and equip the Union Army. At that time, there were 1,600 private banks chartered by 29 different states, and altogether they were issuing 7,000 different kinds of banknotes.

immediately induced the Congress to authorize the issuing of government notes (called greenbacks) promising to pay “on demand” the amount shown on the face of the note, not backed by gold or silver. These notes were issued by the US government as promissory notes authorized under the borrowing power specified by the constitution. The total cost of the war came to $3 billion. The government raised the tariff, imposed a variety of excise duties, and imposed the first income tax in US history, but only managed to collect a total of $660 million during the four years of Civil War. Between February 1862 and March 1863, $450 million of paper money was issued. The rest of the cost was handled through war bonds, which were successfully issued through Jay Cooke, an investment banker in Philadelphia, at great private profit. The greenbacks were supposed to be gradually turned in for payment of taxes, to allow the government to pay off these greenback notes in an orderly way without interest. Still, during the gloomiest period of the war when Union victory was in serious doubt, the greenback dollar had a market price of only 39 cents in gold.

Undoubtedly these greenback notes helped Lincoln save the Union. Lincoln wrote: “We finally accomplished it and gave to the people of this Republic the greatest blessing they ever had - their own paper to pay their own debts.” The importance of the lesson was never taught to Third World governments by neo-liberal monetarists.

In 1863, Congress passed the National Bank Act. While its immediate purpose was to stimulate the sale of war bonds, it served also to create a stable paper currency. Banks capitalized above a certain minimum could qualify for federal charter if they contributed at least one-third of their capital to the purchase of war bonds. In return, the federal government would give these banks national banknotes to the value of 90 percent of the face value of their bond holdings. This measure was profitable to the banks, since with the same initial capital, they could buy war bonds and collect interest from the government, and at the same time put the national banknotes in circulation and collect interest from borrowers. As long as government credit was sound, national banknotes could not depreciate in value, since the quantity of banknotes in circulation was limited by war-bond purchases. And since war bonds served as backing for the notes, the effect was to establish a stable currency.

The system did not work perfectly. The currency it provided was not sufficiently elastic for the needs of an expanding economy. As the government redeemed war bonds, the quantity of notes in circulation decreased, causing deflation and severe hardship for debtors. Money seemed to be concentrated in the Northeast, while Western and Southern farmers continued to suffer chronic scarcity of cash and credit, not unlike current conditions faced by Third World debtor economies.

After the Civil War, the Independent Treasury continued in modified form, as each administration tried to cope with its weaknesses in various ways. Treasury secretary Leslie M Shaw (1902-07) made many innovations; he attempted to use Treasury funds to expand and contract the money supply according to the nation’s credit needs. The panic of 1907, however, finally revealed the inability of the system to stabilize the money market; agitation for a more effective banking system led to the passage of the Federal Reserve Act in 1913. Government funds were gradually transferred from sub-treasury "vaults" to district Federal Reserve Banks, and an act of Congress in 1920 mandated the closing of the last sub-treasuries in the following year, thus bringing the Independent Treasury System to an end.

Populism and Monetary Politics

John P Altgeld, a German immigrant populist who became the Democratic governor of Illinois in 1890, attacked big corporations and promoted the interest of farmers and workers, to give the state an able, courageous and progressive administration. The question of currency was central to the US populist movement. Farmers knew from first-hand experience that the fall in farm prices was caused by the policy of deflation adopted by the federal government after the Civil War and only ineffectively checked by the Bland-Allison Act of 1878, coining silver at a fixed ratio of 16:1 with gold, and the Sherman Silver Purchase Act of 1890. The Treasury’s redemption of silver with gold increased the value of money and deflated prices.

Despite the rapid growth of business, the government engineered a sharp fall in the per capita quantity of money in circulation. The National Bank Act of 1863 also limited banks’ notes to the amount of government bonds held by banks. The Treasury paid down 60% of the national debt and reduced considerably the monetary base, not unlike the bond-buyback program of the Treasury in 1999. To farmers, it was unfair to have borrowed when wheat sold for $1 per bushel and to have to repay the same debt amount with wheat selling for 63 cents a bushel, when the fall in price was engineered by the lenders. To them, the gold standard was a global conspiracy, with willing participation by the US Northeastern bankers - the money trusts who were agents of international finance, mostly British-controlled.

President Grover Cleveland, despite winning the 1892 election with populist support within the Democratic Party, gave no support to populist programs. Cleveland saw his main responsibilities as maintaining the solvency of the federal government and protecting the gold standard. Declining business confidence caused gold to drain from the Treasury at an alarming rate. The Treasury then bought gold at high prices from the Morgan and Belmont banking houses at great profit to them. Populists saw this effort to save the gold standard as a direct transfer of wealth from the people to the bankers and as the government’s capitulation to international finance capital. Cleveland even sent federal troops to Illinois to break the railroad strike of 1894, over the vigorous protest of governor Altgeld.

The election of 1896 was about the gold standard. Cleveland lost control of the Democratic Party, which nominated 36-year-old William Jenning Bryan, who declared in one of the most famous speeches in US history (though mostly shunned these days): "You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold." The banking and industrial interests raised $16 million for William McKinley to defeat Bryan, who suffered a defeat worse than Jimmy Carter’s by Ronald Reagan. With the McKinley victory, the Hamiltonian ideal was firmly ordained, but with most of its nationalist elements sanitized and replaced with a new finance internationalism. It was not dissimilar to the Reagan victory over Carter in 1980 in many respects.

The 16th amendment to the US constitution calling for a “small” income tax was enacted to compensate for the anticipated loss of revenue from the lowering of tariffs from 37 to 27% as authorized by the Underwood Tariff of 1913, the same year the Federal Reserve System was established. “Small” now translates into an average of 50% with federal and state income taxes combined. Free trade is only free in the sense that it is funded by the income tax.

The supply-side argument that corporate tax cuts stimulate economic growth only holds if the at least half of the benefits of the tax cut are channel toward rising wages, instead of higher return on capital with the additional benefit of lower capital gain tax. Thus a case can be made to couple all corporate tax cuts with an index on wage rise to match or exceed corporate earnings. One of the reasons why strong corporate earnings have not help the current credit crisis can be traced to the disproportional rise in equity prices having come from stagnant wages in the same corporations.

The Glass-Owen Federal Reserve Act was passed in December 1913 under the administration of President Woodrow Wilson. The system set up five decades earlier by the National Bank Act of 1863 had two major faults: 1) the supply of money had no relation to the needs of the economy, since the money in circulation was limited by the amount of government bonds held by banks; and 2) each bank was independent and enjoyed no systemic liquidity protection. These problems were more severe in the South and the West, where farmers were frequently victimized by bank crises often created by Northeastern money trusts to exploit the seasonal needs of farmers for loans. To this day, the Fed operates a seasonal discount rate to handle this problem of farm credit.

The Northeastern money elite in 1913 wanted a central bank controlled by bankers, along Hamiltonian lines, but internationalist rather than nationalist to make the US an global financial powerhouse. But the Wilson administration, faithful to Jacksonian tradition despite political debts to the moneyed elite, insisted that banking must remain decentralized, away from the control of Northeastern money trusts, and control must belong to the national government, not to private financiers with international links, despite the internationalist outlook of Wilson. Twelve Federal Reserve Banks were set up in different regions across the country, while supervision of the whole system was entrusted to a Federal Reserve Board, consisting of the Treasury secretary, the comptroller of the currency and five other members appointed by the president for 10-year terms.

All nationally chartered banks were required and state-chartered banks were invited to be members of the new system. All private banknotes were to be replaced by Federal Reserve notes, exchangeable at regional Federal Reserve Banks not only for bonds or gold, but also for top-rated commercial paper, with the hope of causing the money supply to expand and contract along with the volume of business. With the reserves of all banks deposited with the Federal Reserve, systemic stability was supposed to be assured. Unfortunately, systemic stability has been an elusive objective of the Fed throughout its history of 94 years, largely due to the Fed fixation on the market rather than the economy. To the Fed’s thinking, even today, the market drives the economy, not the other way around. Take care of the market, and the economy will take care of itself. Unfortunately for the Fed, this fixation has been proven wrong throughout history. The market is but a gauge on the economy. If the economy is running empty, fixing the gauge does not fix the real problem.

The Fed’s Ineffectual Response to the August 2007 Credit Crisis

The equity market’s decade-long joy ride on the Fed’s easy money policy came abruptly to an end in August 2007. Having lowered the discount rate 50 basis points to 5.75% but kept the Fed Funds rate target unchanged at 5.25% on August 17 in response to the outbreak of the credit crisis, which the Fed adamantly but mistakenly thought to be containable, the Federal Open Market Committee (FOMC) was forced on September 18 to again lower the discount rate another 50 basis point to 5.25% and the fed funds rate target 50 basis points to 4.75% as the credit market continued to deteriorate. Six weeks later, on October 31, 2007, the FOMC, trying to correct a massive credit market failure, once again lowered the discount rate another 25 basis points to 5% and the fed funds rate target another 25 basis points to 4.5% to try to inject liquidity into the severely distressed banking system.

In an accompanying statement on October 31, the Fed continued to paint a comforting picture that economic growth was solid in the third quarter of 2007, and strains in financial markets had eased somewhat on balance since August.  However, the Fed qualified its denial by saying: “the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.” That action, combined with the policy action taken in September, was expected “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.”

By November 27, the DJIA intraday low had dropped 1,000 points to 12,711.98 from the October 31 intraday low of 13,711.59, having reached an intraday high of 14.168.51 on October 12. Market anticipation of more Fed interest rate cuts to lift the market pushed the DJIA back up to 13,727.03 by December 11, on which day a panicked Fed again lowered the discount rate by 25 basis points to 5.75% and the fed funds rate target by 25 basis points to 4.25%. A disappointed market which had expected a 50 basis point cut saw the DJIA drop 295 points to close at 13,432.77.

The Fed was reduced to playing short-term yo-yo with interest rates driven by the stock market at the expense of its mandate to guard against long-term inflation. The Bureau of Labor Statistics (BLS) reported that the Headline Consumer Price Index (HCPI) for November 2007 was 4.3% higher than November 2006, and 5 basis points higher than the Fed Funds rate target of 4.25%.

Fed Interest Rate Cuts Puts Downward Pressure on the Dollar

The Fed’s interest rate actions put continued downward pressure on the both the exchange rate and the real purchasing power of the dollar, thus further increasing inflation in import and domestic product prices, especially oil for which the US is both an importer and a producer. January oil price futures for April 2008 delivery jumped $1.35, to $88.75 a barrel. Since April 2006, core inflation has remained within the 2.2 - 2.3% range, higher than the unofficial targeted inflation rate of 1.6% to 1.9%. This hampers the Fed’s ability to lower interest rates further without unleashing inflation down the road.

Core and Headline Inflation

For the typical household, the total or headline inflation, which includes volatile food and energy price components, is what counts because headline inflation measures the rate at which the cost of living is rising against relatively stagnant household income. A high headline inflation rate relative to income growth causes household standard of living to fall.

For the purpose of calibrating monetary policy, however, the Fed focuses on the core rate of inflation: the total excluding food and energy prices, on account that the core is less volatile and is deemed a better reflection of the interplay of supply and demand in domestic product markets. Thus, the core traditionally is a better gauge of the underling rate of inflation in the absence of external supply shocks.

By contrast, food and energy prices can be extremely volatile from month to month due to temporary supply disruptions related to weather or to political crises. In those instances, headline inflation tends to be less representative of the underlying rate of inflation. Headline inflation has relatively minor macroeconomic impact; it tends to shift revenue from one sector to another. When oil prices rise, oil company revenue increases while consumer expenditure rises. The net result is a higher GDP figure but not necessarily a larger economy. Yet this rationale is less operative in the current situation where both energy and food prices have risen dramatically with volatility along an upward curve and imported oil payment has become a major item in the
US trade deficit.

The historical record of the
US economy is that headline and core inflation have averaged about the same over the long run. Over the past two decades, annual inflation as measured by the Personal Consumption Expenditure (PCE) deflator averaged 2.6%, while price increases as measured by the core PCE deflator averaged 2.5%. Data from the past ten years pose a challenge to the rationale for focusing on the core. Over that period, crude oil prices have been volatile, rising from below $10 per barrel in early 2000 to near $100 currently. Food prices and that of other commodities are also rising at an above normal rate. Such rise is no longer expected to be temporary. They tend to stay high for long periods because of the long-term decline of the dollar, which has become the main factor behind global hyperinflation trends. Thus even if the headline inflation rate eventually moderates from month to month, prices can stay high relative to income. Inflation readings from price levels independent of income levels are not informative on the health of the economy.

on core inflation were interpreted by the Fed as having improved modestly in October 2007, but increases in energy and commodity prices in the second half of the year, among other factors, might put “renewed upward pressure on inflation.”  In that context, the FOMC judged that “some inflation risks remained, and it would continue to monitor inflation developments carefully.” The FOMC, after its October 31 action, judged “the upside risks to inflation roughly balance the downside risks to growth.”  The Committee would “continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”

The single dissenting vote against the FOMC easing action was Thomas M. Hoenig, who argued for no cuts in the federal funds rate at the meeting. In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 5%.  In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, St. Louis, and San Francisco.

Market Disappointment

On December 11, the Fed again cut the discount rate at which it lends directly to banks by 25 basis points to 4.75%, and the Fed Funds rate 25 basis points to 4.25%, halving the normal interest penalty on discount window. The market was visibly disappointed. US stocks fell sharply after the central bank cut the Fed Funds rate by only 25 basis points to 4.25% rather than the expected 50 basis points, and the market interpreted Fed language as failing to offer a clear signal of more cuts to come. The DJIA dropped 295 points to close at 13,432.77. The S&P 500 closed down 2.5% at 1,477.65, after being up 0.4% before the decision was released. Still, the yield on the two-year Treasury note fell to 2.92%, down from 3.14%, exerting downward pressure on the dollar. By January 8, 2008, the DJIA had fallen 843 points to 12,589.07.

The Fed said the deterioration in financial market conditions had “increased the uncertainty surrounding the outlook for economic growth and inflation.” But while it dropped its assessment that the risks to growth and inflation are “roughly balanced”, the Fed did not say that it now believed the risks to growth outweigh the risks to inflation. It offered no assessment of the balance of risks, saying it would act “as needed” to foster price stability and sustainable economic growth. This formula in effect meant the Fed was keeping its options open pending incoming data which are notoriously inaccurate and inevitably have to be revised in subsequent months.

Some market participants still inferred a willingness on the part of the Fed to consider future rate cuts, but the signal was weaker than many had expected. This reflected the fact that the Fed remained more concerned about the risks to inflation than most market participants who are more concerned with short-term profitability than the long-term health of the economy.

Once market sentiment starts to turn negative and more market participants anticipating a slowing economy if not a recession, market dynamics will shift the smart money toward new profit opportunities, such as going short on shares that depend on growth and going long on shares that will flourish in a recession. This will exert further negative pressure on the market in a self-reinforcing downward spiral.

Also not mentioned was the effect of further interest rate cuts would have on the exchange value of the dollar which had been falling, particularly against the euro. The Fed is always cautious regarding pronouncement on the dollar’s exchange rate because that is the exclusive mandate of the Treasury which the Fed is required by law and constitution to support as a matter of national economic security.

Rise of the Euro

The International Monetary Fund reports that the euro’s share of known foreign exchange holdings rose to 26.4% in the third quarter of 2007, reflecting its increasing strength in foreign exchange markets. That was up from 25.5% in the previous three months and from 24.4% in the third quarter of 2006. The dollar’s share of known official foreign reserves, calculated in dollar terms, fell to 63.8% in the third quarter, down from 66.5% in the same three months of 2006. The trend of rising preference of the euro will strengthen the illusion held by European policymakers that the euro is maturing into a significant rival to the dollar while in fact the euro remains only a derivative currency of the dollar. The euro has been losing purchasing power along with the dollar, and the rise in its exchange value against the dollar merely signifies that the euro is depreciating at a slightly slower rate than the dollar. Dollar hegemony is a geopolitical phenomenon with a financial dimension, by virtue of the fact that all key commodities are denominated in dollars.  When the European Central Bank (ECB) intervenes to halt the rise in exchange value of the dollar, it in effect accelerates the decline of the euro’s purchasing power. The same holds true for the Japanese yen or the Chinese yuan.

The Fed said on December 11, 2007 that “incoming information suggests that economic growth is slowing” reflecting an “intensification of the housing correction” and “some softening in business and consumer spending.” It acknowledged that “strains in financial markets have increased in recent weeks”. However, the US central bank still had made almost no changes to its cautionary language on inflation, reiterating that “energy and commodity prices, among other factors, may put upward pressure on inflation.”

Six weeks later, on January 22, in response to sharp declines in all markets around the world from the bursting of  the debt bubble, the Fed reversed itself diametrically and dramatically to announce a cut of 75 basis points of the fed funds rate target to 3.50%, throwing inflation concern to the wind. Yet the DJIA closed on January 22, 2008 at 11,973.06, down 126.24 points, or 1.04% from the previous Friday, but still higher than the October 17, 2006 close of 11,950.02, and 4,586.79 points, or 63% higher than the October 9, 2002 close of 7,286.27. Evidently, the Fed cast a visible vote for inflation to sustain the bursting debt bubble.

Fed Introduces Discount Loan Auction to Reduce Stigma

The Fed is not expected to eliminate the discount rate borrowing penalty altogether because such a step would allow a large number of small banks to obtain funds at less than their usual spread over the fed funds rate, and would complicate efforts to manage the fed funds rate through the open market. At the same time, the Fed was considering ways to try to reduce the “stigma” associated with using the discount window for the big banks, in order to make it more effective as a backstop to the money markets.

As a solution, the Fed overhauled the way it provides liquidity support to financial markets, following a negative market reaction to the timid December 11 interest rate cut. The overhaul took the shape of a new liquidity facility that will auction loans to banks. This would allow the Fed to provide liquidity directly to a large number of financial institutions against a wide range of collateral without the stigma of its existing discount window loans. The idea is that this would ease severe strains in the market for interbank loans, and help restore more normal conditions in credit markets generally as banks were getting reluctant to lend to each others for fear of counterparty default.

In a speech in early December, Fed vice-chairman Donald L. Kohn said “the effectiveness of the direct lending operation was still being undermined by banks’ fear that using it would be seen as a sign that they needed emergency funds. The problem of stigma is even greater in the UK where, following the Northern Rock debacle, banks are afraid of tapping funds from the Bank of England.” 

Kohn said all central banks – not just the Fed – had to find new ways to ensure that their liquidity support facilities remained effective in times of crisis. “Making the Fed discount window more usable is particularly important because all banks can pledge a wide range of securities in return for cash at this facility. Only a small number of primary dealers can access cash from the Fed through its main market liquidity facility – open market operations to control the fed funds rate – and the list of collateral that can be pledged is much narrower,” Kohn said.

Coordinated Effort by Central Banks

Euro money market rates tumbled
after the European Central Bank (ECB) injected an unprecedented $500 billion equivalent into the banking system on December 18, 2007 as part of a global effort to ease gridlock in the credit market. The amount banks charge each other for two-week loans in euros dropped a record 50 basis points to 4.45%. The rate had soared 83 basis points in the previous two weeks as banks hoarded cash in anticipation of a squeeze on credit through year-end. The ECB loaned a record 348.6 billion euros ($501.5 billion) for two weeks at 4.21% on that day, almost 170 billion euros more than it estimated was needed. Bids were received from 390 banks, ranging from 4% to 4.45%.

A coordinated effort by central bankers helped the credit markets and specifically the London Interbank Offer Rate (LIBOR) which had drifted to an 85-basis-point spread from the fed funds rate. That widening spread was a clear signal of distress in the credit markets. It showed that banks were risk averse in their lending habits and were reluctant to lend to each other out of concern for counterparty risk.  Getting LIBOR back in line, within 10-12 basis points of the fed funds rate historically, was a top priority to soothing the pain in the credit markets.  The Financial Times quoted Goldman Sachs economist Erik Nielson: “This is basically Father Christmas to those who have access to central bank funds]. They are bailing out people who have not really adjusted their balance sheets to the new reality.”

Fighting Deflation with Negative Interest Rates

Low and frequently negative real interest rates over long periods of time had created the debt bubble, the bursting of which resulted in the credit crisis of August 2007. Central banks are now responding to the bursting of the debt bubble by cutting interest rates yet again. Central banks seem to be letting unreliable incoming raw economic data on the previous month to drive interest rate policy which at best can only have longer term effect. The addiction to negative real interest rate to sustain the debt bubble will eventually lead to a toxic financial overdose.

Lessons of the Great Depression of the 1930s and the protracted Japanese recession of the 1990s have left all central banks with a phobia about asset deflation, against which monetary policy of zero nominal interest rate can have little effect. Since nominal rates cannot go below zero, deflation, or negative inflation, implies positive real interest rates even as nominal rate is zero, causing central banks to lose their ability to provide needed economic stimulus by monetary means. In a deflationary environment, borrowers will find it more costly to repay loans of even zero interest rate. The history lesson learned by central bankers is that when an asset-price bubble bursts with threats of deflationary recession, monetary policy therapy has to be dramatic, timely and visible to be effective.

Next: Inflation Targeting