It was supposed to be about US monetary policy. Yet, as Ben Bernanke (pictured left), chairman of the Federal Reserve, outlined his "exit strategy", he was dragged into the stimulus debate, coruscated for supervision of systemic risk and warned that he risked feeding political turmoil. Equity and debt markets did pay attention to monetary matters during Mr. Bernanke's biannual speech to the House financial services committee on Tuesday, watching as he counted tools to unwind the central bank's unconventional way of stimulating credit flows. The Fed has lowered interest rates to close to zero to support the recession-ravaged economy and pumped liquidity into the system through various programmes, including the purchase of $300bn of Treasury bonds. To reverse course, Mr. Bernanke noted, the Fed could raise rates on reserves that institutions were holding at the central bank – "banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free". … "For the Fed, the issue is not primarily ‘do you have a plan'," says John Silvia, chief economist at Wells Fargo. "We know the Fed has a plan – that's not the issue. Will they implement and follow through?" The Fed's method of raising interest rates may be different this time, but it still has to choose exactly when to start that process. Too soon and the nascent recovery could peter out. Too late and inflation could take hold. "It's a very difficult problem," said Mr. Bernanke on Tuesday. "And even though, you know, we have these unusual circumstances, it's really the same problem we always face . . . picking the right moment to begin to tighten and picking the appropriate pace of tightening." – Financial Times
Dominant Social Theme: Bernanke acknowledges challenges.
Free-Market Analysis: Never has the American Federal Reserve been so challenged by Congress, or not for the past 50 years anyway, not since the Great Depression, actually. We've been following what we believe to be the unraveling of the Fed, and Bernanke's appearance on the Hill yesterday exposed the chairman and his organization to fairly withering criticism. Bernanke was asked about his authority to make US$500 billion in loans to overseas central banks, why he didn't believe an audit of the Fed was appropriate, why he believed the Fed should receive expanded authority – and why he figured he could bring the country out of recession.
This last point was especially critical because, in fact, Bernanke ended up confronting the one element of Fed policy which is both the most critical and the most unknowable. It has to do with the choices being made about monetary policy. The Fed like other central banks only guesses when it makes monetary policy, and these guesses are compounded when it comes to larger monetary movements. Here's what Bernanke said yesterday as reported in the article excerpted above:
The Fed's method of raising interest rates may be different this time, but it still has to choose exactly when to start that process. Too soon and the nascent recovery could peter out. Too late and inflation could take hold. "It's a very difficult problem," said Mr. Bernanke on Tuesday. "And even though, you know, we have these unusual circumstances, it's really the same problem we always face . . . picking the right moment to begin to tighten and picking the appropriate pace of tightening."
This is indeed the problem, and it is good to hear Bernanke address it. The Fed and other central banks have dumped trillions into the markets, and all this monetary inflation will eventually be manifested as price inflation. Therefore, this money must be sterilized – drained – from the larger economy before it poses problems. But first, one needs to pick the right moment to tighten, and then one needs to figure out the pace of the tightening.
The trouble is that Bernanke knows very well, as Alan Greenspan before him, that there are no tools that allow central banks to look into the future. Thus these government banks will always use – at least in the 20th and 21st centuries – variants of statistical modeling. Econometrics – math-heavy economic modeling – is the lingua franca of modern Western economics. It looks and sounds impressive, even though it does not work and cannot work because models cannot predict the future with any accuracy.
Bernanke, for instance, like all intelligent and proficient statisticians, is comfortable with the language of econometrics. But when pressed he will admit that the models created are just that. No matter how much data is utilized, no matter how smart the modelers are, the models and the decisions based on them will inevitably be wrong. Bernanke may have a number of exit strategies in mind, each more sophisticated than the last, but he has NO tools that tell him when to apply these strategies and how fast.
In fact, were Bernanke pressed, he would have to admit that the chances of the Federal Reserve being wrong about tightening and its pace are probably 100 percent. That is because free-market economics tells us that human action is the uncontrollable element in forward-looking central planning. Any trend that economists can discern is bound to be vitiated by HUMAN ACTION. It is human action itself, humanity's resolve to change unhappy or destructive circumstances that changes the trend in defiance of projections. It is always thus, which is why centralized planning never quite predicts the reality.
Bernanke can promise that the Federal Reserve and other central banks will ultimately "get it right" when it comes to figuring out how to manage the inflationary trends already in the economy. But there is no way that central banks over time can deal successfully with the unfolding crisis. They will try of course but in doing so will basically end up creating further financial bubbles or providing a kind of scorched earth policy that will slow economic activity to a painful crawl. Either way, the result will be that a new monetary system will emerge out of the ashes of what went before. In fact, central banks will likely try to convince their citizens that the new system should resemble the old. But we tend to believe by then that some sort of money metals standard will win the day. We are as confident of the possibility of a gold standard as Bernanke apparently is in his own acumen.