This post attempt to assess what powers the fed has to control inflation, deflation, and economic growth. The key word in that sentence is “control”. Let’s take a look at where we are today.

The Fed is only in control (using the word loosely as we shall see in a moment) of base money supply, reserve requirements, and short term interest rates. Even then the fed can not target money supply and interest rates at the same time. The Fed can target reserve requirements and either money supply or interest rates (but not both). Yet the myth persists that “the Fed is Pumping M3”, that Fed has the power to “drop money out of helicopters” and as one person actually proposed “add zeros to everyone’s account” to prevent deflation.

In practice, the Fed would not add money to people’s accounts or drop money out of helicopters even IF the Fed could do it. The Fed would not do such things because it would destroy banks and creditors (their own cartel) to bail out consumers. Thus his infamous speech Deflation: Making Sure “It” Doesn’t Happen Here can best be described as “Bernanke’s Bluff”. If deflation was so easy to prevent in practice, Japan would not have endured it for decades.

Yes the Fed will likely slash interest rates but at some point that “magic” will cease to work except perhaps to raise the price of gold. The reason it will not work is simple: there is too much overcapacity and malinvestments already. Slashing rates will not stimulate jobs, home building, capex spending, or anything else productive. This by the way is exactly why Bernanke is wrong about the cause and cure of the great depression. The cause of the great depression was the rampant increase of money supply and credit leading up to it. It is illogical to assume the cure (increasing money supply and lowering interest rates) is same as the cause.

Magic Powers of the Fed

In reality, the Fed has no magic powers. The Fed can not create jobs, drop money out of helicopters, cause wages to rise, set interest rates in Japan, force China to float the RMB, stop various carry trades, or add zeros to everyone’s account. It is amazing the powers people attribute to the Fed.

Consider The Real Economy

  • Rising bankruptcies and foreclosures
  • Implosion of 23 subprime lenders
  • A stalled GDP
  • Rising inequities between the “haves” and the “have nots”
  • ISM under 50
  • Inverted yield curve (Yes, Bernanke it still means what it used to)
  • Credit standards starting to tighten over default fears
  • Rising weekly jobless claims

Consider Financial Speculation

  • Junk Yield Spreads vs. Treasuries
  • Leveraged Buyout Mania
  • Stock buybacks on bowwowed money
  • Parabolic charts on emerging markets
  • Carry Trade in full force

What Can the Fed Do?

Bernanke ‘s problem in a nutshell is that interest rates are no longer supportive of the real economy (primarily because there is rampant overcapacity and malinvestments everywhere) even if they are not restrictive enough (for now) to stop wild financial speculation in various carry trades, credit swaps, leveraged buyouts, and stock buybacks.

Can the Fed put an end to that speculation by targeting money supply instead of interest rates? Perhaps, but what would that do to housing and the real economy? Can the Fed target interest rates? Yes, but if they do, then money supply is not in their hands. No matter how one twists and turns the Fed can not control both money supply and interest rates. The Fed gets to pick its poison in that regard.

Can the Fed stimulate jobs? Not really, unless they can reignite the housing bubble. Is that likely? Would they do it even if they could? If they did manage it, would it do anything but postpone the problem? The Fed can (and will eventually have to) raise reserve requirements. Because of sweeps and fractional reserve lending there are essentially no reserve requirements now. There is only an illusion of reserve requirements. This is clearly one of the things the Fed allowed to get out of control and for now there is no good solution.

Eventually this will blow up just as every asset and financial speculative bubble in history has blown up. That is the message conveyed in Central Bankers Cry Wolf.

Weber: European Central Bank council member Axel Weber said investors shouldn’t expect central banks to bail them out in the event of an “abrupt” drop in financial markets. “If you misprice risk, don’t come looking to us for liquidity assistance,” Weber said in an interview in Davos, Switzerland at the annual meeting of the World Economic Forum. “The longer this goes on and the more risky positions are built up over time, the more luck you need.”

Trichet: Current conditions in global financial markets look potentially “unstable”, suggesting that investors need to prepare themselves for a significant “repricing” of some assets, Jean-Claude Trichet, president of the European Central Bank. “We are currently seeing elements in global financial markets which are not necessarily stable,” he said, pointing to the “low level of rates, spreads and risk premiums” as factors that could trigger a repricing.

Poole: “The Fed can provide liquidity support but not capital”.

Poole’s statement is critical: “The Fed can provide liquidity support but not capital“. That is an accurate assessment of the situation, and it is in start contrast to those who think the Fed can drop money out of helicopters or add zeros to peoples accounts. Liquidity support would most likely come from extremely short term borrowing and/or lowering of interest rates.

The most important facet of all of this is that monetary claims very likely exceed the pool of real funding by several orders of magnitude. When push comes to shove, this house of cards will eventually collapse in some way.

Rampant Inflation

Professor John Succo wrote an interesting article on Minyanville last week entitled Rampant Inflation.

Why would the Federal Reserve minutes show concern for inflation? Consumer prices certainly seem under control (although I can argue that the BLS measure of that is flawed). The reason is most people have a misconception of what inflation is. The Fed members must understand the real problem. The problem is dire.

Inflation is the growth in money and credit and it is growing like a weed. The Fed stopped publishing M3, the broadest measure of this money, so most don’t even talk about this troublesome statistic. It’s clearly growing much faster than nominal GDP and illustrates the devastating nature of the Fed’s policies.

If you reconstruct M3 it is currently growing at around 12-13%, a level which has rarely been seen, a level way above average and one that is ultimately deflationary (at some point it will get so large that it must be paid back or defaulted on).

The U.S. saw a total of $4 trillion in new credit created last year. All that money you see out there has been borrowed.

Normally all that money would go to bid up consumer prices. It is not because of the U.S.’ sickness.

All that free money (first fostered by Japan’s ridiculously low interest rates, a rate that was just raised yesterday because it is clearly causing malinvestment) combined with globalization has created overcapacity. The latest capacity numbers show it now falling from already below average numbers. The U.S. has too much production in the world so producers can’t increase prices. The U.S. has too many houses so the prices are beginning to fall. The U.S. has too much commercial real estate so REIT stocks are showing severe weakness. The U.S. made too many risky loans so the subprime mortgage market is falling apart. The U.S. has too many strip malls so the countryside is getting ugly.

All that borrowed money is now going into speculation because there is nothing left to build. It is going into stock prices, gold, commodities as the last flushes before the market says “we can’t take anymore debt.” Total U.S. debt is 3.5 times GDP, a level never seen before. The second highest level was 2.9 times in 1929. Total U.S. financial debt (excludes consumer debt) is 2.1 times GDP, the highest ever and up from one time in 1987.

The timing is uncertain, but logic tells us that this must end.

Thank’s professor Succo and Minyanville. It is important to keep harping about what inflation is and what it isn’t. Eventually it will sink in (I hope). And speaking of hope….


  • The Fed is now hoping that subprime blowups do not filter through into higher grades.
  • The Fed is now hoping that jobs do not collapse.
  • The Fed is now hoping that the inverted yield curve does not mean what it used to.
  • The Fed is now hoping that financial speculation stops before things blow up.
  • The Fed is now hoping that it has found the “magic interest rates” for a soft landing.

Any action the Fed might take right now risks imploding the real economy or further inflating financial speculation. The situation, however, is now so far out of Bernanke’s control that the Fed’s economic policy has now been reduced to misguided hope.

Mike Shedlock / Mish/