The Fed’s Balancing Act
With the rate of inflation rising, the prices of corporate stocks retreating, and economic activity slowing, Federal Reserve Chairman Ben S. Bernanke and his fellow governors face an onerous decision. If they should continue to raise interest rates in order to check inflation, they may burden the economy and precipitate a recession. But if they should choose not to act at all, or even reduce their rates in order to stimulate economic activity, they may allow inflation to accelerate. The core inflation rate, which excludes energy and food, already approaches 3 percent a year. It may continue its upward march.
At stake is the Fed’s credibility as an inflation fighter and economic regulator, at least as perceived by most Americans. This writer views the Fed in an entirely different light. He sees a federal agency that has gradually gained control over the American money and credit system. Since its inauguration in 1914, it has reduced the U.S. dollar by some 95 percent of its purchasing power and is diluting it more every day. And the economy has suffered from chronic cyclical instability. Another recession is on the horizon.
Most Americans believe that recessions are phenomena inherent in market economies and that government has the power and obligation to correct the evil. They want the Federal Reserve to provide the funds and the U.S. Treasury to adopt “contra-cyclical measures,” such as public works and other full-employment programs. They do not want government to raise taxes or borrow the necessary funds in the open market, which would not increase the aggregate amount of spending. Under the influence of Keynesian and Neo-Keynesian thought, they view deficit spending as a way out of recession and depression. Unfortunately, such policies tend to make matters worse; they feed the inflation and aggravate the economic decline, which the shrinking dollar and numerous recessions clearly indicate.
Most Americans probably never heard a frank and impartial explanation of the business cycle. They do not realize that economic stagnation and recession are the final phase of a business cycle, the readjustment phase. A cycle begins when the Federal Reserve System, in order to stimulate the economy or assist government deficit financing, lowers its discount rate below the actual market rate at which the supply of and demand for savings are evenly matched. Or it may decrease interest rates through open-market operations of buying government securities. Capital at bargain rates excites many businessmen and encourages them in their investment decisions. They may expand and launch many new projects which make business thrive and boom. But as soon as goods prices and wage rates begin to rise, businessmen need additional funds. As long as the Fed provides them, the boom can continue and even accelerate. It comes to an end when the Fed ceases to throw new funds on the loan market or the quantity launched no longer suffices to feed the boom. At that time, the readjustment, that is, the recession begins.
The present cycle undoubtedly began after the bursting of the stock market bubble in 2000 and the terror attacks on the United States in 2001 when central banks everywhere braced for deflation and recession. In fear and trepidation they lowered their interest rates, the Bank of Japan to zero, the Federal Reserve to one percent, and the European Central Bank (ECB) to two percent, the lowest levels since World War II. In most countries the policy seemed to work as housing construction, which always is interest-rate sensitive, came to life again. Even the doubling of oil prices and other energy costs could not dampen the excitement. Goods prices rose moderately due to low-cost imports and some relocation of production, but business profits improved visibly
Artificially low interest rates not only stimulate economic production but also excite capital markets. As corporate profits rise, stock prices tend to soar. Real estate prices increase as buyers can shoulder greater mortgage debt. Even the loan market may flourish as foreign banks, for various reasons, acquire large quantities of American I.O.U.s. Massive trade deficits always add their quandary and risk. Last year, the U.S. balance-of-payments deficit amounted to $805 billion or 6.4 percent of gross national product. This year, it is expected to be even larger.
Fears of growing imbalance and potential crisis finally prompted central banks to raise their rates, at first the Fed, then ECB, and now also the Bank of Japan. The Fed raised its discount rate 15 times in ¼ percent increments to 4.75 percent, ECB twice to 2.75 percent, the Bank of Japan tightened its discounts and advances. But these reactions merely moved the rates closer to the true market rates. The central banks did not set the markets free to find their true demand-and-supply rates which are “gross rates” consisting of three distinct components: (1) an originary rate which reflects the lower valuation of all future goods when compared with present goods; (2) an inflation component which compensates lenders for the depreciation of their money during the loan; (3) a debtor’s risk component which is determined by the credit rating of a debtor; it usually is negligible in Federal Reserve loans to member banks. But the other two components are ever present. Originary rates reflect human nature and inflationary components mirror the anticipated rate of money depreciation. At the present, this writer surmises a gross market rate of some five to six percent consisting of 2-3 percent originary rate and 3 percent inflation component. If inflation should accelerate in coming months, the gross rate may rise much higher in anticipation of more inflation to come.
No matter where the Fed may set its rate, it is unlikely to be the true market rate; it may cause new maladjustments while many businessmen are laboring to correct their old mistakes. All along, legislators and regulators are sitting in judgment of the monetary policies conducted by the Federal Reserve governors. They are interrogating and quizzing them frequently and adding their recommendations. When interest rates are rising and some maladjustments become visible, they sound the alarm about Fed “overshooting” the interest rate. But when the governors lower the rate, the political directors usually applaud and acclaim the policy. They pay great tribute to former Federal Reserve Chairman Alan Greenspan for having lowered the discount rate to one percent when the economy was about to readjust.
No matter what the future may bring, legislators and regulators everywhere will hold forth about monetary matters. Foreign central bankers and regulators will hold American officials responsible for the pains of maladjustments. Their American counterparts surely will return the charge: According to Fed Chairman Ben Bernanke, “The main causes of the imbalance lie outside the United States. Less developed countries seek to expand their export industries which generate trade surpluses. The United States merely is a willing recipient of their exports. The Fed is rendering an important balancing service.” And American legislators and regulators like to add joyfully: “The lion’s share of American debt is denominated in U.S. dollars while most American investments abroad are stated in foreign currencies. A fall of the dollar obviously diminishes American debt while it raises the value of American investments abroad, enriching American investors. Nothing is said of the countless victims at home and abroad who are suffering in silence.
The Fed’s “balancing act” is a political composure act that seeks to please legislators and regulators sitting in judgment of Federal Reserve policies. Popular monetary and economic thought obviously shape their policies. Ever since the 1930s popular thought has been molded by various schools of inflationomics, such as Keynesian and Institutionalist thought, that made the U.S. Treasury responsible for prosperity and full employment and the Federal Reserve for providing the necessary funds. They have fashioned the trade-cycle system and relied on a Federal Reserve balancing act ever since.
Hans F. Sennholz