Bernanke Has Snookered Us All

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:

Forecasting what the FED will do is like reading tea leaves. But let me give it a try.

The FED 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 rate.

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:

This 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 day.

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:

While 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 Statistics.”

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? Deflation.

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 base.


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:

Federal Reserve charts Yield curvePrice 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 rate.

Normally, 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.

Repurchase 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 back.

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 money.

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.”

The 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 assets.

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

May a depository institution pledge sub-prime mortgages?

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

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.

Meanwhile, 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.


Eventually, 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 doing.


I 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.

September22, 2007

Gary 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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