Why Bernanke Cannot Keep Inflation at Bay

Ben Bernanke claims the Fed has plenty of tools to keep its recent and unprecedented monetary expansion from resulting in price inflation:

"We are quite confident that we can raise interest rates, reduce the money supply and do that all in a timely way to avoid any inflationary consequences," Bernanke told the House of Representatives Financial Services Committee in a second day of testimony on the Fed's monetary policy report.

Sounds reassuring, doesn't it? The problem is, the Fed is between a rock and a hard place. I do not think it can help but cause very, very high levels of inflation, and quite possibly destroy the dollar in the process at this point. I've already posted several times on the massive increase in the Adjusted Monetary Base since last September. The money, fortunately, is still sitting in the vaults of the Fed, thanks to a very fearful financial system which is unwilling to lend, coupled with the Fed beginning to offer interest for deposits held there. There are basically three ways the Fed can prevent price inflation at this point: sell assets, raise interest rates through market intervention, and offer interest on deposits it is holding. We'll go through all three. Selling Assets The lion's share of the increase in the AMB occurred when the Federal Reserve bought up mortgages and other shaky securities in the various "bailout" programs we've all been hearing about, especially TARP. When the Fed buys assets, it does so with money which did not exist before, essentially creating it out of thin air, thus expanding the monetary base. That money goes out and circulates in the economy just like any other money, thereby increasing the money supply. The Fed's assets represent the "backing" of the nation's currency. In a pinch, such as a crisis in confidence in the currency, the Fed can "defend" the dollar by selling these assets back into the market, drawing currency out of the market and into its vaults, reducing its supply and thus raising its value. This very situation recently occurred in Russia, and apparently there is some doubt that Russian reserves are sufficient to fend off the present crisis. In the old days, the Fed bought gold, as did most central banks around the world, so gold was the backing of the dollar. This was the essence of the "gold standard." Paper money could be "redeemed" for this gold by buying the gold back from the Fed with the very money the Fed had issued. This promise to redeem money for gold gave people confidence in the value of the dollar. Between abandoning the gold standard in 1971 and last September, 2008, the Fed mostly held US Treasury debt. So the currency issued by the Fed was backed by credit record of the United States of America and the governments ability to tax its citizens to pay the debt. Now the Treasury certificates are mostly gone, having been lent out in the TAF program to clean up the balance sheets of the ailing banking system. These were replaced by shaky mortgage paper and other questionable assets that banks wanted to "temporarily" get off their books. So, in summary, the US Treasuries are mostly gone, the gold is mostly gone, and these have been replaced, and augmented with, all the horrible loans we keep hearing about on the news. These are the assets presently backing the US dollar. You can see a graph of all of this here. The point of all this is to show that to reduce the money supply by selling assets, the Fed will either have to part with what is little left of its "good" assets, the gold and US Treasuries, or try to sell off all those bad loans. Obviously, it cannot sell the bad loans. The whole point of holding them was to cover up the fact that they are awful assets. If the Fed sold now, it would not be able to get anywhere near the price it paid for them, and the effect would be to deal a severe blow to the banking system without effectually reducing the money supply. We would actually be worse off than before with respect to the solvency of the US banking system. The Fed would not do this unless the crisis was already over and these assets assumed a more normal valuation. These assets will never have a normal valuation. If there were any possibility for this, the Fed would not have had to buy those assets in the first place. The only way for that to happen would be for all those mortgages to get paid off, or for housing prices to return to where they were, which would require the mass inflation the Fed is trying to prevent. The Fed is in a catch-22 with respect to its mortgage paper. I think the Fed is stuck with all of it. Selling US Treasuries would have the effect of increasing the interest rate paid by the Federal Government at a time that it is running up very, very large debts. In fact, the Fed has been mulling buying US Treasuries to help the government borrow at lower rates and push down long term interest rates, at the expense of dollar holders, of course, so it would seem bizarre to consider selling them to reduce the money supply. It would also probably trigger a worldwide selloff of US Treasuries, which would be catastrophic to the dollar. This solution is simply unthinkable. All that is left is gold. The government prices the gold it is holding at $42 per oz, which is positively foolish, but I suppose that is the price of pride. $42 per oz is what gold last traded while the US was still on the gold standard. At any rate, pricing the gold at market prices of nearly $1000 per oz substantially increases the value of the Fed's holding. But even if the Fed sold all of its gold at this price, it would fetch about $250 billion by my estimate, barely putting a dent in the monetary expansion that has occurred thus far (about $1 trillion). So this wouldn't work. Raising the Interest Rate Manipulation of the interest rate is what Fed watchers normally pay attention to. Normally, the Fed only intervenes to lower the rate. It does this by entering the market and lending when no other banks will, once again, using money that did not exist before. This increases the money supply. It could artificially raise the rate by entering into the market and borrowing money, driving up interest rates, soaking up dollars, and reducing the money supply. Theoretically, at least, this would work. However, politically the Fed cannot do this. The present economy is literally addicted to monetary expansion. Without continuous monetary expansion, and the low interest rates that expansionary policy produces, a vast swath of the US economy would not be profitable. Which, I suppose, technically means that it is not profitable now in real terms, but is being propped up by said government intervention. America had a stable money supply through late 2007 and most of 2008. It promptly tanked. To effect an actual reduction in the money supply, the Fed would have to raise rates above natural market rates. Basically, this policy would bring to bear very powerful recessionary forces on the economy. It would also induce real, actual deflation. Doing it would be the right thing to do of course, but it would ensure that the economy underwent a massive contraction, including persistent, very high unemployment for quite a long time. This would be very politically unpopular. It would also ensure the bankruptcy of the US government. The US government needs enormous tax revenue to pay off the debts it has incurred and is presently running up. Deflation, a contracting economy, and its consequences on tax revenue would be a death sentence. The Fed cannot do this. Paying Interest on Deposits Paying interest on deposits held at the Fed is really only a stopgap measure. It only prevents banks from using their money to make new loans, which temporarily keeps the money out of the marketplace, but it does nothing to reduce the money supply. In fact, because the interest payments are of newly created money, it actually expands the money supply slowly. So this is really not a solution at all. Conclusion The options available to the Fed to reduce the money supply appear at this point to be impotent. Ben Bernanke's only hope is for the economy to improve to the point that he can sell assets. But as we have seen, by the time that happens, the inflation will by necessity already have taken place, thanks to the economy's present addiction to an expanding money supply. There is one other option available: increase reserve requirements. This will prevent the banks from lending the money altogether. It will not reduce the money supply, but it will prevent that money supply from being used to bid up prices as it is multiplied by the fractional reserve system. However, to do so would be a repudiation of fractional reserve banking, anathema to the banking community, and a heresy to modern economic thought. It would be a step in the direction of a proper Austrian banking system. This step will likely not be taken. Inflation is virtually guaranteed.