The question on my mind today is: Can the Fed Control Prices? In Long-Rate Folderol Is Reaching Inflection Point Caroline Baum quotes Bernanke as follows:

Fed Chairman Bernanke pretty much summed up the official party line in a March 30, 2005, speech, when he was one of seven governors on the board. The Fed has “no direct control over the key interest rates and asset prices that jointly determine the extent of financial stimulus,” Bernanke said. Instead, policy makers are stuck setting “an otherwise obscure short-term interest rate, the federal funds rate.”

There you have it. Bernanke admitted that he has no control over asset prices or even key interest rates. But does he have control over any prices? For that, let’s take a look at Fed Isn’t Boxed in by Open Windows or Dry Powder. Caroline Baum writes:

The Fed’s dual mandate — maximum sustainable growth and price stability — is fine for public consumption: It keeps members of Congress off its back. But as far as policy makers are concerned, price stability is both an end in itself and a means to that end and therefore commands the upper hand.

The idea that a central bank can produce faster growth by tolerating a little more inflation has been “entirely discredited,” Bernanke said last week in a speech to the National Bureau of Economic Research’s Summer Institute in Cambridge, Massachusetts. “Policies based on this proposition have led to very bad outcomes whenever they have been applied.”

So maybe this is a new era of straight talk (OK, they could improve on the boilerplate statement) and a crooked tilt except when deflation, or a decline in the price level, threatens.

Even then, it seems, the Fed would still be more concerned about prices than growth. After all, in the long run, prices are all it can control.

Bernanke might agree with that last sentence (after all he does want an inflation target of 2%), but I strongly disagree.

What the Fed can control.

  • Base Money Supply
  • Short Term Interest Rates

That’s it. If the Fed could control prices, oil would not be over $70 a barrel, food prices would not be soaring and housing prices would not be collapsing. Perhaps someone wants more exclusions as to what prices the Fed is not in control of.

Prices the Fed clearly does not control

  • Food prices
  • Energy prices
  • Shelter prices
  • Equity prices
  • Asset prices

But the list does not stop there. Can the Fed control the cost of medical care or is the that too heavily influenced by various government giveaways like Medicaid and Medicare? Can the Fed control shirt prices? How? Isn’t one of factors influencing the price of shirts the price of raw materials making up the shirt? Isn’t a huge portion of the cost labor costs? Does the Fed control labor costs in China? Can the Fed control runaway government spending? If not, how can it control any prices?

Can someone name the price of any goods or services the Fed is in control of? I can’t think of one (unless you call a short term interest rate a price). Interestingly enough I agree with two statements made by Bernanke:

  • The Fed has “no direct control over the key interest rates and asset prices that jointly determine the extent of financial stimulus”
  • The idea that a central bank can produce faster growth by tolerating a little more inflation has been “entirely discredited”

Out of Control

With M3 expanding at close to 13% the Fed is clearly out of control. But the Fed likes a good party. It helped create the biggest bubble to date in both consumer credit and housing. Supposedly this must be “good inflation” because it primarily affected asset prices like houses and equities. For some reason the Fed can’t control those but it can control other prices even though I challenge anyone to name the price of anything the Fed can control.

Oddly enough Bernanke claims to know that “faster growth does not come by tolerating more inflation” yet has embarked on the most extreme if not downright insane fiscal policy the world has ever seen. Bernanke can’t see it because he ignores asset bubbles just as the Maestro (Greenspan) did.

Nonetheless the Fed can (and does) micromanage base money supply and short term interest rates. This management is quite like the failed central planning strategies of Russia and China. When monetary policy is too loose one of two things typically (but not necessarily) happens: Prices in general rise or asset prices rise. It is the latter that creates bubbles because the Fed ignores them until things get out of hand.

Furthermore the Fed is in a Fool’s Fantasyland from the start because prices cannot be accurately measured and also because there is no such thing as a representative basket of goods and services to begin with. For more on the difficulty of measuring prices please see Inflation: What the heck is it?

When the world was more US centric than it is today, the Fed arguably had “more influence” on prices than it does today, but it never had “control”. And although the US is still the top economic dog, its importance is decreasing over time. The Fed cannot set wages in China, Brazil, or Vietnam. Nor can it control demand at the margin for base metals in China. Nor can the Fed control oil prices ever because of growing peak oil constraints. Nor can the Fed control the price of gold or silver. Nor can the Fed rein in government spending.

Simply put, the Fed simply is not in control of any prices and its ability to even influence prices of any kind is diminishing given the ever increasing influence of a truly global economy vs. a US centric economy. What the Fed can do however, is encourage speculation by keeping interest rates too low (on purpose or by accident). But unfortunately for the Fed, it cannot control which asset prices or prices in general change by that encouragement nor can it control the bubble that ultimately results.

But the important point here is that the Fed can only encourage speculative activity. A limiting factor arises because the Fed simply cannot force speculative borrowing. Eventually there comes a time when the whole system breaks down simply because the Fed can lower rates but it can’t force consumers to borrow or businesses to invest. (See Interview with Paul Kasriel for more discussion of this idea).

That is when the payback comes from years of ignoring and/or directly encouraging asset bubbles to form. When it happens, we will see the emperor has no clothes when it comes to controlling prices, controlling speculation, and controlling the expansion or contraction of credit itself.

Caroline, I am going to let you take that one back. The Fed is not in control of prices no matter how much they want everyone to think they are.

By the way, it’s easy to pluck a single sentence out of a lengthy article and beat the heck out of it. That is not the intent of this post nor does it diminish my respect for Caroline Baum. (For my two thumbs up review of her book, please see Bookmobile: Master Traders & Just what I said.)

I am sure I have said a dozen things over the past year that would have me asking “Did I really say that?” Rather, this article came about because I simply liked the idea of discussing what the Fed is in control of, or not. As powerful as the Fed is, the answer (from where I sit) sure is not prices. And one look at M3 tells me the Fed is not in control of credit either. More precisely, the Fed is clearly out of control.

It’s time to abolish the Fed and restore fiscal and monetary sanity. The way to make that happen is to vote for Ron Paul.

This is a long video but if you have not yet heard Ron Paul @ Google please play it.

Ron Paul is the only candidate that wants to get the Government, the Fed, and the IRS out of our lives.

Mike Shedlock / Mish/