The Foreboding Signal of the Fed Cut
by Bob Murphy
by Bob Murphy
As most people have heard by now, on Tuesday the Federal Reserve cut its target for the fed funds rate by 50 basis points. (A basis point is .01 percentage points.) Most analysts expected that the Fed would cut rates at least 25 basis points, in light of the recent turmoil in the credit markets and the worst employment figures in August in four years. However, the more aggressive cut of 50 bps surprised many, and in the aftermath many mainstream commentators have questioned whether the Fed went "too far."
Austrian economists are aware of the evils of fiat money and central banking; after all, we mean it when we say that counterfeiting makes us all poorer and central planning doesn't work. But I think Tuesday's aggressive cut is much more alarming than other comparable moves. Tuesday's decision was the first big test for Chairman Bernanke, and by disappointing even the Wall Street Journal editorial board (let alone hardcore gold bugs), Bernanke signaled that he is afraid of being labeled "heartless." Unfortunately, having such a softie at the Fed's helm couldn't have come at a worse time.
Once the "conservative" Richard Nixon closed the gold window, the dollar naturally collapsed throughout the 1970s. Paul Volcker finally said enough is enough and jacked up interest rates in late 1979. What followed were the relatively severe recessions of 1980 and then 1982. However, Volcker did manage to break world investors out of the vicious downward spiral of expectations of double-digit inflation. What followed was certainly not a golden era, but nonetheless a relatively strong economic recovery, with low rates of unemployment and price inflation — something that the traditional Keynesian analysis had said was impossible.
Austrians and other enthusiasts of the gold standard sometimes downplay how significant expectations are when it comes to the purchasing power of money. This is understandable, because so often Fed officials and other commentators excuse the dastardly role of fiat money creation when talking about rising prices. These apologists make it sound as if the CPI just rises on its own like topsy, and gosh if only we could figure out how to contain it! The only way to contain price inflation, of course, is to limit the creation of new money — and this is precisely the virtue of a true gold standard.
But as I say, I think this focus on the supply side often leads hard-money enthusiasts to overlook the importance of the demand side, specifically of expectations. Consider the following exaggerated thought experiment: Even if the overall quantity of U.S. dollars in circulation were held at a fixed level, nonetheless if everybody were firmly convinced that inflation would be at least 50% next year, then this prophecy would be self-fulfilling. Certain that prices would soon rise sharply, people would rush to spend their dollars, and this would push up dollar-prices. In essence, the same stock of dollars would be circulating much more rapidly, supporting a much higher level of "average" prices (if you don't mind that term).
So what does all this have to do with Bernanke et al.'s decision on Tuesday? The context of their aggressive cut is a dollar that is at its weakest level in 30 years. (Indeed, during my lifetime I had always gotten more Canadian dollars when I'd cross the border to go gambling or drink legally — I was a college freshman in Michigan. But now the USD is actually trading at parity or at a discount to the Canadian dollar.) The forces are in place, in my opinion, for the USD to fall much further against other currencies.
The one thing holding back the floodgates has been the USD's position as reserve currency to the world. Basically, foreigners (especially governments) have been buying massive quantities of dollar-denominated debt instruments to finance our unprecedented trade imbalances.
But now with the recent cut, it's that much more likely that people around the world will find the spell broken. This could cause a stampede away from the dollar, and lead to a self-fulfilling prophecy — though one supported by the fundamentals. Although I am naturally suspicious of all central bankers, some are better than others. But it looks like Bernanke does not have the courage to stem the fears of inflation. This coupled with a potential Clinton presidency and Democratic Congress, at precisely the time when a major recession could hit, is very troubling indeed.
September 24, 2007
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