What are the limitations of the Fed’s power? It’s neither impotent nor omnipotent!

Larry Kummer, Editor

12 years ago

Summary: Although one of the most power agencies of the US government, obsessively discussed in the financial news, it remains one of the least well understood. Here we examine the limitations on its power. Readers can decide for themselves if these limitations are too tight, or too loose. Next in a series about Central Banks, the giants of State power.

The power of Central Banks
Inflation
Hyperinflation, the quick killer
Deflation, the quiet killer
Legitimacy — the ultimate limit
For More Information

(1) The power of central banks

The development of central banking in the century before WWI was one of the last few innovations necessary to produce the nearly omnipotent modern State. Central banks provided the mechanism to not only easily finance large projects, such as wars and great societies, but also harness large banks to the State’s needs (for their mutual gain).

The ability to print money, set interest rates, and harness banks’ power to lend gives the illusion of omnipotence. But life means limits. Central banks have both hard boundaries to their abilities — and a hidden weakness.

Central banks have well known limits to their powers of monetary stimulus, no matter how exercised.

For more about the Federal Reserve see What every American needs to know about the Federal Reserve System.

(2) Inflation

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
— Milton Friedman, The Counter-Revolution in Monetary Theory (1970).

Central banks can stop and start inflation by controlling the nation’s money supply. Stopping inflation requires painful measures, but with the certainty of success. Starting and managing useful inflation requires more skill.

Why create inflation? Unanticipated inflation acts as the magic sauce of monetary policy. Quiet, mild, relentless. It lowers the real interest rates. If we also have wage growth slightly above inflation, then our crushing debts evaporate painlessly (as we erased aprox 1/3 of our WWII debt). Bernanke literally wrote the book on this, Inflation Targeting (1998).

There are two limits to central bank’s ability to manage inflation. First, the nation’s currency. The central bank can expand the money supply without limit — with effects varying depending on its internal circumstances. But it will depress the value of the currency. A weak currency can boost exports, beneficial if not offset by the increased cost of exports (eg, China and Germany have done this successfully). At some point, however, a currency collapse comes — with horrific consequences.

The second limiting factor: it requires marks — people unaware of the coming inflation and its consequences. That was so in Germany and Austria after WWI (in the early 1920’s), just like Americans in the late 1960’s and 1970’s (our first peacetime inflation). Next time we won’t be so easy to fool. Inflation was the formative economic experience of the boomers. Like “survivors” of the Great Depression, they have waited their entire lives for a repeat of this formative experience — what would be their greatest opportunity to gamble and win!

The more people prepare for inflation, the less the government benefits from it. Consider the situation (exaggerated for emphasis) in 2 years (to pick an arbitrary number), when (if) the recovery comes. Everybody (including elderly widows in Smallville) will own only hard assets, inflation protected securities, or short-term debt. The average maturity of the Federal debt will be 2 weeks (vs. about 4 years today). Under these circumstances the government must avoid inflation, as the resulting increase in its interest cost would be lethal. Just like Japan today, with its debt of 2x GDP and of a short average maturity.

With QE3 the Fed seeks to induce a controlled reflation so that real short-term treasury interest rates go negative. It’s one of the few treatments for a liquidity trap (see Wikipedia). They seek moderate inflation so that investors and businesspeople will act on the lower real rates — but without sacrificing the Fed’s credibility as an inflation-fighter won during the past 34 years. It’s a delicate game, discussed in the next post of this series.

Posts about inflation:

(3) Hyperinflation, the quick killer

“Hyperinflation is always and everywhere a fiscal phenomenon”
— Economists’ aphorism, source unknown.

Hyperinflation is a dire risk for a State. Not suicidal, as often described (the hyperinflation of 1921-1924 weakened the Weimar Republic, but it was the deflationary collapse of 1929-1932 that brought Hitler to power in 1933). But the destructive powers of hyperinflation have been long known. So why do nations resort to it? It’s a choice, made when the alternative is default: the State’s inability to pay its bills. During wartime, defeat. The danger of hyperinflation seems — and often proves to be — the best available course.

Hyperinflation is the monetary result of a fiscal problem. Hyperinflation reflects a limitation of Central Bank authority: ultimately they’re a State institution, and must obey commands even it results in the loss of their institutional credibility.

Posts about hyperinflation:

(4) Deflation, the quiet killer

Deflation is the quiet killer of high-debt economies, like ours. A small decrease in prices over a few years can initiate debt deflation and depression. Even a high savings economy like Japan has suffered since the 1989 crash, locked into a low-growth mode sustained only by massive fiscal deficits which will eventually destroy their political regime (and which may have already passed the point of no return).

Ben Bernanke’s famous speech about deflation explains why a Central Bank can always win: “Deflation: Making Sure ‘It’ Doesn’t Happen Here“, Remarks before the National Economists Club at Washington DC, 21 November 2002. In it he explains why the US need never again experience deflation:

“But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

The Fed’s success since 2007 vindicated his bold words, as they neutralized the massive deflationary effects of the crash and subsequent long recession. But their laurels might be undeserved. As described in last week’s post, the emerging nations have massively expanded their monetary supplies since 2007, and this excess liquidity has sloshed around the world — and might have played a large role in stabilizing the world. Now their current account balances shrink, as do their massively purchases of western nations’ securities. The next year will show what effects this has, and if there remains a deflationary impulse in the developed nations, Central Banks ability to defeat deflation will again get tested.

Posts about deflation:

(5) Legitimacy — the ultimate limit

*the Fed is like “the chaperone who has ordered the punch bowl removed just when the party was really warming up.”
— attributed to William McChesney Martin Jr, Chairman of the Fed from 1951-1970.

Central Banks were designed as independent, more or less, for two reasons: to allow politicians to allow others to take unpleasant decisions (eg, starting recessions to cool an overheated economy) and to have greater institutional credibility as inflation-fighters than the legislature.

This creates an inherent weakness: unelected officials (in the US many are banker officers) making political decisions. If they fight inflation, they’re blamed for the higher interest rates and recessions. If there is a long period of inflation — even slow inflation, like during the 99 history of the Fed) — they’re condemned as incompetent (even if much of that was designed as a benign way to pay down war debt).

This weak legitimacy has often worried the Fed leadership, restraining their response to even visible problems until they had support from elected officials. The best example is the 1978 Humphrey Hawkins Act and the appointment of Volcker. The first de facto authorized the switch to monetarism as Fed doctrine by required the Fed to set one-year target ranges for money supply growth twice a year and to report the targets to Congress (The experiment quickly failed, and this requirement was abandoned when it expired in 2000. See this this NY Fed paper for details.). The latter, a response to the rapidly worsening financial balances of the US economy, gave a new Chairman the legitimacy to inflict great pain to achieve a cure.

Now we face another difficult time, in some ways worse than 1978. Again the Fed tries new solutions, although no theory as well-developed and radical as monetarism. The difference is that one major party has made hostility to the Fed a core party of its platform. The Republican Party platform advocates another commission to study the desirability of a gold stand (like the one 30 years ago). GOP legislatures support bills to radically restructure the Fed (eg, this bill by Rep Kevin Brady (R-TX), Vice-Chairman of Congress’ Joint Economic Committee). Conservative publications seethe with hostility to the Fed. Errors by the Fed, real or imagined, will greatly embolden its opponents.

A part of America’s public policy apparatus, Fed remains such subject to changes in Congressional sentiment. They are independent only so long as they retain the confidence of a majority in Congress. The Fed’s leadership has to worry about institutional legitimacy of the Fed should they adopt radical new policies that earn the enmity of one of the two major parties. That’s the ultimate limitation on their actions. Today, as the Fed takes another step of unconventional monetary policy, legitimacy is the only visible limit on Fed action.

Worrying about the Fed’s diminished legitimacy:

“GOP Fed up with Ben Bernanke” at Politico.
“Restoring The Legitimacy Of The Federal Reserve“, Simon Johnson (former Chief Economist, IMF) at the Baseline Scenario.

Posts about legitimacy:

Undercutting people’s trust in the Republic: another step to destroying the Republic — Attacking the Fed is part of a larger project.
Why do so many Americans want a gold-based currency?.
What would a gold-backed currency do to America?

(6) For More Information

Some posts about monetary policy:

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