Bernanke boxed in

2011-APR-30

After the first-ever Fed press conference, gold and silver rose sharply. This was hardly a vote of confidence in paper money.

Perhaps the event and the Federal Open Market Committee statement that preceded it were over-hyped, but both events were disappointing – ducking as they did the important issue of what happens after QE2 is completed. The statements on inflation did little more than recognise a temporary and small – or “transitory” – pick-up in prices. By revising downwards estimates for economic growth over the next few years, the Committee claims that inflation will probably subside. In any event, the Fed is more concerned with the risk of inflation being closer to zero, given the risk that the economy might then tip into deflation.

All in all, the statement and the press conference exposed the weakness of the Fed’s position. We are left with the thought that if a Paul Volcker were in charge, things would be very different. A return to sound money and a stabilised dollar would be a pre-emptive strike against both global and US inflation, and the experience from the Volcker era is that economic growth was much better than might have been expected following interest rates of 20%.

But there is a crucial difference today compared with 30 years ago. The level of private sector debt is substantially higher, and shows a strong tendency towards contraction. High interest rates are not actually needed to reduce demand, because bank credit, which is the counterpart of private sector debt, has been contracting of its own accord. It is this that frightens the Fed most, because contracting bank balance sheets are very difficult to manage without risking a full-blown banking crisis.

So it is the difficulty of keeping the banking system running while there is credit deflation in the air that actually pre-occupies the Fed. This is more important than the official mandate of maintaining a low rate of inflation consistent with high employment. But by focusing on keeping the banking system solvent, the Fed is taking enormous risks with monetary inflation. The unprecedented growth in raw money, reflected in the increase of the monetary base since the Lehman Bros crisis, has been designed to offset the contraction of broader credit, and is deemed by the Fed to be non-inflationary overall.

Economists generally support this view, taking comfort from the build-up of bank deposits on the Fed’s balance sheet in the form of non-borrowed reserves. They argue that only when the banks draw down on these reserves to use as a base for further bank lending will the inflation risk escalate. But this argument ignores the fact that this money is already in circulation through government spending.

There may have been nothing new from the FOMC statement, and nothing about QE3, but in the absence of more positive measures the markets have the confirmation they need that the dollar is headed lower. The Fed is boxed in. No wonder gold and silver rose so sharply.