Bernanke's Surprise

You have read about the turmoil in international capital markets. It began on August 11. Highly rated packages of mortgages suddenly became unsalable. Their value went into free fall. Banks and brokerage firms have lost well over $150 billion since August. Northern Rock, Great Britain’s fifth-largest bank, was nationalized on Sunday, February 17. Otherwise, it would have gone bankrupt on Monday. UBS, the huge Swiss bank, has lost about $10 billion. “Round and round it goes. Where it stops, nobody knows.”

The Federal Reserved in mid-August immediately intervened in a series of actions to liquify the American banking system. You have probably read about this, too. The FED’s discount window started taking subprime mortgages as collateral for loans to the banks applying for loans.

You have read the headlines about the Federal Reserve’s new policy of inflation to solve the credit crisis.

I ask you bluntly: “Have you reallocated your investments so as to hedge against the FED’s wave of fiat money?” Be honest. Have you?

I hope not. Why? Because the reports are all wrong. I don’t mean a teeny-weeny bit wrong. I mean completely wrong.

The FED has not been inflating. The FED has been deflating.

Hard to believe? It surely is. I find it difficult to believe myself. I had thought the FED would inflate (“Reality Check,” August 28). So did everyone else. But the data are clear. The FED has shrunk the money supply since mid-August, 2007.

In support of this, I offer evidence from the FED itself. I have assembled the data and the charts. Click the link. (If you have money on the line, you had better click the link.)

The FED can reverse itself at any time. What it has been doing is not set in concrete. At some point, the FED will reverse its current tight-money stance. But until it does, I suggest that you do not “fight the tape.” The FED is not printing money to save the economy. It is doing the exact opposite. It is burning money, conceptually speaking.


Jesus said, regarding charity, do not let one hand know what the other is doing. Bernanke is applying this principle to credit creation. On the one hand, the FED is making loans to banks based on dodgy collateral. On the other hand, it is selling high-quality credit instruments, primarily Treasury debt. I see no other explanation that is consistent with the data: liquidity for banks coupled with falling monetary base and falling M1.

Why would the FED adopt such a policy? Because it has to choose between two competing goals. Rarely is this the case, but it is today.

First, save the banks. Central banking is the fractional reserve commercial banking system’s ace in the hole. The FED is the lender and therefore stabilizer of last resort. It has only two tools, says Franklin Sanders: fiat money and blarney. These days, it is relying exclusively on blarney.

Second, save the dollar. The FED receives its monopoly over the money supply from the U.S. government. The Board of Governors of the Federal Reserve System is legally an agency of the U.S. government. This is why it does not pay for postage. This is why its domain name is The government expects the FED to maintain a market for the government’s debt.

In the past, this has meant that the FED must buy Treasury debt whenever private investors have refused to buy it at interest rates that the Treasury is willing to pay. The FED has intervened to buy this debt, especially in wartime.

Some people think the FED holds most of the U.S. government’s debt. This is incorrect. The FED publishes this information weekly. This is the H.4.1 release: “Factors Affecting Reserve Balances of Depository Institutions.” As of Feb. 14, 2008, the FED held $713 billion in U.S. Treasury debt.

To check what the on-budget (not Social Security and Medicare) U.S. debt is, see the debt clock here.

It grows by the second, but the total is a little under $9.26 trillion. So, the FED is not the primary holder of Treasury debt. American investment funds and foreign investors are, especially foreign central banks.

The Federal Reserve must now take into consideration foreign demand for Treasury debt. If the rate of interest on Federal debt falls, due to fear over a recession — the “flight to safety” — the FED has a problem. If foreign governments offer higher rates of return than the Treasury, foreign capital may flow into these debt markets. The possibility of a flight from the dollar by foreign central banks and investors becomes a threat.

This would undermine the dollar’s position as the world’s reserve currency. It is this unique position that has allowed the government to sell its debt to foreigners and inflate at the same time, sticking the buyers with currency losses. It has allowed the FED to print currency, which is sent home by immigrants living in the United States. This money remains abroad. So, the money is not spent here. It does not drive up prices. This is called “exporting inflation.” It does in fact operate with exported currency.

The FED can inflate in order to forestall a looming recession, or at least mitigate its effects. It can create money. This has the effect of lowering the Federal Funds rate — the rate at which American banks lend to each other overnight. It can also lend through the discount window, quietly, to keep rumors from spreading about a bank’s trouble. It can also lend through a newly created program, the Term Auction Facility (TAF).

The effect of these policies, unless offset by the sale of Treasury debt by the FED, is to lower interest rates. Lower interest rates send a signal to foreign central banks and investors: more fiat money, higher prices, lower value of the dollar. This message is risky during a period in which there has been a slow but steady shift out of the dollar. The dollar has been falling in value internationally for five years. There is a move away from the dollar as the international reserve currency. It is not a mad dash for the exits by any means. For as long as the commodity futures markets and financial markets are denominated in dollars, the dollar’s role will remain strong. But the preliminary signs of a move away from the dollar are becoming obvious.

The FED normally would have lowered the FedFunds target rate by expanding its holdings of Treasury debt. The monetary base would have risen. M1 would have risen. But both have fallen since mid-August. Something is restraining the FED. Some concern is keeping the FED from countering an international credit crunch with a monetary policy to increase liquidity.

The standard effect of such a policy is a reduction in the FedFunds rate. That rate has fallen. But it has not fallen as far as the 90-day T-bill rate has fallen. The T-bill rate went under 2% for one day on January 31 — a full percentage point below the FedFunds rate. It is now in the 2.2% range, not quite a percentage point below the FedFunds rate. This took place during a period in which the adjusted monetary base declined.

The common interpretation given to this fall in the FedFunds rate has been “Federal Reserve inflation.” This interpretation is incorrect. There have been ups and downs in the monetary base since mid-August, but the general trend has been down by 0.4% at an annual rate.

This has been a major surprise to me. It has yet to become a surprise to the financial media, which have ignored this unforeseen and unexpected policy.


Bernanke has come, slowly and not surely, to a forecast bordering on “recession ahead.” His words are guarded, but we can see a shift in perspective over the last seven months. He dismissed the suggestion before August. He does not dismiss it today.

In his testimony to the Senate Banking Committee on February 14 (Valentines Day), Bernanke summarized the areas of concern: falling real estate prices, losses by banks, and rising unemployment. These words were decidedly non-Greenspanian.

. . . other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for the economy, have also roiled the financial markets in recent months. . . .

Banks have also reported large losses, reflecting marked declines in the market prices of mortgages and other assets that they hold. Recently, deterioration in the financial condition of some bond insurers has led some commercial and investment banks to take further markdowns and has added to strains in the financial markets.

He also warned about rising oil prices as part of the “inflation front.” This, of course, is economic nonsense. Rising oil prices do not cause price inflation. If oil prices rise, then consumers must cut back elsewhere in their budgets. Cost-plus inflation is a fallacious idea based on ancient fallacies that should have died off after the rise of modern economic theory in the 1870’s. But it is still popular, even at Princeton University, I guess.

He was correct regarding the following:

To date, inflation expectations appear to have remained reasonably well anchored, but any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring inflation expectations and the inflation situation more generally.

The FED is still taking appropriate actions against inflation expectations. It is deflating. But Bernanke will not admit this. He continued to provide the standard central banking party line to the Senate.

In the area of monetary policy, the Federal Open Market Committee (FOMC) has moved aggressively, cutting its target for the federal funds rate by a total of 225 basis points since September, including 125 basis points during January alone. As the FOMC noted in its most recent post-meeting statement, the intent of these actions is to help promote moderate growth over time and to mitigate the risks to economic activity.

He refused to say exactly what the FED did that was aggressive. Reducing the money supply is not what most people envision when they hear a FED Chairman speak of moving aggressively. The FED cut the target FedFunds rate. Well, not exactly. The FOMC announced a cut at a time when the T-bill rate was falling. In fact, the FED was playing catch-up with the T-bill rate. I am tempted to call this a rate accompli.

Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation, as well as the risks to that forecast. At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt.

There is indeed a fiscal stimulus: a $150 billion increase in the Federal deficit. Our checks will be in the mail. But where, pray tell, is the monetary stimulus? So far, there has been the opposite of a monetary stimulus. There has been a monetary contractus. That is why I agree with this statement.

At the same time, overall consumer price inflation should moderate from its recent rates, and the public’s longer-term inflation expectations should remain reasonably well anchored.

The threat of price inflation is being dealt with properly by the FED’s monetary policy. The FED is contracting the money supply. That is going to put downward pressure on prices. Note: listed prices are not the same as “have I got a deal for you” prices.

Housing prices are headed lower — much lower in the bubble regions. The FED’s policy is guaranteeing this. Bernanke was wise to admit this possibility.

Although the baseline outlook envisions an improving picture, it is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further.

This was not the happy-face spin of Tout TV and the mainstream media. He closed his remarks with the familiar refrain: “We will keep an eye on this.”

The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

Oh, yeah?


The bullish stance of American investors is being hit hard by a falling stock market and falling real estate prices. The hope of most investors who are long — and most are long — is that the FED will intervene on the side of the bulls. In fact, the FED has been intervening on the side of the bears.

Because this is so far out of character, the media are blind to the data. They listen to Bernanke’s assurances of aggressive monetary policy and think, “stimulus.” He even says this magic word.

Do what Nixon’s Attorney General John Mitchell once said: “Watch what we do, not what we say.” They did, and he went to jail.

Watch the statistics of what the FOMC has done, not what Bernanke says they have done. If you don’t, you’re in for a big surprise.

February 23, 2008

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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