Bernanke Has Snookered Us All

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Ben the Beard
has put the shuck on all of us: hard-money fanatics, Wall Street
analysts, and full-time FED-watchers. He has done it in plain site.
He and his accomplices have left a trail of digits, but nobody has
followed the trail. Until now. And even I may have wandered off
the trail.

On August
28 in “The Fed’s
Next Moves
,” I wrote:
what the FED will do is like reading tea leaves. But let me give
it a try.

doesn’t want to send a message of panic, so it will not lower
the FedFunds target rate until its next scheduled meeting, which
is September 18. At that meeting, it will announce a rate cut.
The FED will cut it by at least .25 percentage point. But to be
sure that bankers know the FED means business, I think it will
be .50 percentage point, matching the cut in the discount window’s

At the time, a
forecast of a half-point cut was considered improbable. Most FED-watchers
thought .25 point was likely. As you know, the FED cut the target
rate by half a point. I also wrote:
will be heralded by the financial media as a sign that it’s time
to buy stocks. The increase from 1% in 2003 to 5.25% in 2006 was
also seen as a signal to buy stocks. Everything is the media’s signal
to buy stocks.
Sure enough, when
the announcement of the half-point cut was issued late in the day,
the Dow Jones rose by 335 points. It rose almost 100 points the next

To make myself
look like a genius, I should leave it at that. But because of what
has happened in the last month, I must fess up. The following paragraph,
as of today, was dead wrong:
the FED is now pumping in new reserves at a little under 6% per
annum, and I expect it to continue this policy for the foreseeable
future, I don’t think this will be enough to reverse the sagging
economy in the next six months. But if I am wrong, then we can expect
a return of accelerating price inflation.
Bernanke and the
Federal Open Market Committee (FOMC) have done something extraordinary.
They have publicly lowered the FedFunds target rate, and have forced
down the actual FedFunds rate to meet the target rate, while deflating
the money supply.

You read it
here first: “deflating.”

The only monetary
indicator that reveals directly what the FOMC has done in recent
weeks is the adjusted monetary base. This is the one monetary aggregate
that the FOMC controls directly. It reveals what actions the FOMC
has taken.

The adjusted
monetary base serves as the monetary base of the fractional reserve
commercial banking system. Take a look at what happened from the
middle of August, when the FOMC lowered the discount window’s interest
rate from 6.25% to 5.75%, until mid-September. You probably have
to see it to believe it.

From early
July, 2007, to mid-August, it climbed rapidly. From mid-August to
mid-September, it fell just as sharply.

This is deflation.

The table
at the bottom of the chart provides the important numbers: the rate
of increase from various dates until now. From mid-September, 2006,
to mid-September, 2007, the increase was 1.8% per annum. This is
what it has been ever since Bernanke took over on February 1, 2006.

An increase
of 1.8% is tight money policy by previous FED standards. I have
been hammering on this point for a year. The FED has dramatically
reduced the rate of monetary inflation.

I don’t think
my message has penetrated the thinking of most hard-money contrarians.
They keep citing M-3, which was canceled by the FED a year ago,
and which was always the most misleading of all monetary statistics.
Year after year, the M-3 statistic was four times higher than the
CPI. The M-3 statistic was worthless from day one. Anyone who used
it to make investments lost most (or all) of his money. I have written
a report on this, which provides the evidence: “Monetary

This tight-money
policy has been reflected in the various consumer price indexes.
This week, the Bureau of Labor Statistics released the figure for
August. The CPI fell by a tenth of a point. That is, the economy
experienced price deflation.

Got that word?

I prefer to
use the Median CPI, which is published by the Cleveland Federal
Reserve Bank. In
August, it rose by two-tenths of a percent.
This is what it
rose every month since March. This means a 2.4% increase, year to
year, which is consistent with the rise in the adjusted monetary


The FED deflated
from the day it announced the cut in the discount rate to the posting
of the latest issue of “U.S. Financial Data.”

Let me ask
you a question. “From what you have read in the hard-money camp,
was it your perception that the FED has been inflating?”

The answer
is “yes,” isn’t it?

There is an
ancient slogan in the newspaper profession: “If your mother says
she loves you, check it out.”

I say: “If
your favorite financial commentator says the FED is inflating, check
it out.”

This brings
me to an important point: you should monitor the statistics carefully
and regularly if you are investing actively. You can do this here:

  1. Federal
    Reserve charts
  2. Yield
  3. Price
    indexes (USA)

Year to year,
the FED is inflating, but it may be inflating far more slowly than
what you have been told. Trust, but verify.


I must now
begin a guessing game. The FOMC does not tell the public exactly
what it is doing. It is not very clear on what it has done. But
we can piece together a pattern from what we have been told.

On September
18, the FOMC announced a half point reduction in the targeted FedFunds

the FOMC controls the actual FedFunds rate by issuing newly created
fiat money to banks in exchange for bank-held assets. These are
called “repurchase agreements.” The FED accepts these from banks
that want to borrow money overnight in order to meet legal reserve
requirements. The banks need more money to lend out. It gets this
from the FED. Here is the description of the arrangement that appears
on Wikipedia.
agreements when transacted by the Federal Open Market Committee
of the Federal Reserve in open market operations adds reserves to
the banking system and then after a specified period of time withdraws
them; reverse repos initially drain reserves and later add them

Under a
repurchase agreement (“RP” or “repo”), the Federal Reserve (Fed)
buys US Treasury securities, U.S. agency securities, or mortgage-backed
securities from a primary dealer who agrees to buy them back,
typically within one to seven days; a reverse repo is the opposite.
Thus the Fed describes these transactions from the counterparty’s
viewpoint rather than from their own viewpoint.

This means that
the FED need not purchase T-bills to inject new money into the economy.
It can purchase other assets. I believe this is mainly what the FED
is buying today. I cannot prove this, but it makes sense. It is trying
to bail out banks that are in trouble and which need very short-term

These assets
are sold to the FED at face value, not market value. The FOMC has
issued a
press release on August 17
which clarified the new situation.
Note the phrase, “a broad range of collateral.”
Board is also announcing a change to the Reserve Banks’ usual practices
to allow the provision of term financing for as long as 30 days,
renewable by the borrower. These changes will remain in place until
the Federal Reserve determines that market liquidity has improved
materially. These changes are designed to provide depositories with
greater assurance about the cost and availability of funding. The
Federal Reserve will continue to accept a broad range of collateral
for discount window loans, including home mortgages and related

But does this
include sub-prime mortgages? Indeed, it does. In a
FAQ on collateral
, we read:
a depository institution pledge sub-prime mortgages?

The Reserve
Banks accept performing mortgages. This could include sub-prime

Second, we
have already seen that the FED was reducing the monetary base.

How could
it reduce the AMB? There is only one way. It had to sell assets.
When the FED sells an asset, the money received from the buyer disappears
— the monetary deflation side of fractional reserve banking.

Third, we
know from the record that the FedFunds rate for over two months
had been pushing against the targeted 5.25% rate. Often, it would
exceed 5.25%. Then the rate would decline, inter-day. Look
at the high-range figures.

My presumption
is that the FED was intervening to supply reserves by buying repo’s.
This, in and of itself, would have increased the monetary base.

Fourth, the
monetary base declined. This requires an explanation. I have one.
The Federal Reserve was simultaneously selling T-bills from its
own account. It sold enough to more than offset its purchases of
repo’s from commercial banks.

The buyers
need not have been American commercial banks. They could have been
foreign central banks, individual investors, and funds looking for
safety/liquidity. The point is, the sale by the FED extinguished
the money that came in from outside the FED.

This solved
the immediate problem: supplying reserves to banks. If the FOMC
bought repo’s of assets other than Treasury debt, this provided
liquidity for assets that would not have been worth as much as the
FED loaned had they been sold into the free market.

the sale of FED assets such a T-bills enabled the FED not to increase
the rate of money growth. It made the repo purchases non-inflationary.

Can this continue?
Yes. Will it continue? For a while, maybe. Bernanke seems determined
to avoid price inflation. There is only one way to achieve this
goal: reduce the rate of monetary inflation. But a policy of monetary
deflation or even slow growth does not solve the problem of the
business cycle. The U.S. economy will slide relentlessly into recession.

The FED is
caught between the rock and the hard place. I believe it will inflate.
But this recent decline in the AMB indicates that the FED is determined
to hold off for as long as politically possible.

If the FED
switches policy, this will be visible in the chart and table of
the adjusted monetary base. You should monitor this weekly.

I may be incorrect
in my analysis. But I can offer no other explanation of how the
FED was able to provide liquidity to the FedFunds market and reduce
the adjusted monetary base at the same time. It had to sell assets.


yes. It has always inflated since about 1938. That is what it does.
That is why it exists.

The crucial
question today is this: Can the FED avoid a recession without re-inflating
seriously? I think the answer is no.

Next: Will
it re-inflate fast enough to avoid a recession? Again, I think the
answer is no.

Next: Will
it re-inflate, once the economy slides into recession? I think the
answer is yes.

In other words,
between today and the next wave of monetary inflation, we are likely
to go through a recession.

You may have
another scenario. You may have a wealth-protection allocation strategy
that is geared for inflation: up, up, and away. If so, I wish you
well, but I think you are wrong.

I think Bernanke
is determined not to inflate. He is willing even to sell T-bills
to offset repurchase agreements.

Whatever the
FED is doing to shrink the monetary base, that is what it has been


am doing my best to stick with the available facts. These facts
are not consistent with what I thought the FED would do, as recently
as August 28. They are surely not consistent with what the hard-money
camp is telling you the FED has been doing.

If your mother
says she loves you, check it out.

22, 2007

North [send him mail]
is the author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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