When Ben Bernanke hosts the first ever press conference by a Federal Reserve Chairman on Wednesday, the subtext will be all about trust — trust in the Fed and the future value of the dollar.
He and his audience are well aware that the danger signs of higher inflation are swirling about – higher energy and food prices, rapidly rising commodity and precious metal prices, and a steady fall in the value of the dollar on foreign exchange markets. But Bernanke is likely to repeat his previous public statements that these price increases are transitory. By so doing, he will attempt to keep inflationary expectations low by promising that the Fed’s efforts to stimulate the economy through an aggressive program of quantitative easing will prove to be non-inflationary.
Just as important, he is likely to repeat his claim first made in his December interview on 60 Minutes that the Fed has the tools and the ability to keep its promise of controlling inflation should he conclude that inflation has, in fact, broken out.
Adhering to these positions may prove to be an “all in” bet by the Fed Chairman. Individuals, companies, and governments all over the world look like they are about to call his bluff. Unless the Fed takes immediate steps to strengthen the dollar, expect distrust in the dollar to grow with a consequent continued slide in its value.
Count me among the skeptics on both promises.
First, the rate of consumer price inflation including energy and food has accelerated into the mid single digits. The three-month annualized increase in the Consumer Price Index (CPI) has gone from 2.9% in September, to 3.3% in December, to 6.1% in March.
The acceleration in more sensitive producer prices has been even more startling, with the three month annualized rate of advance in the Producer Price Index for Finished Goods rising from 4.1% in September, to 9.2% in December and a stunning 13.1% for the three months ending March.
Moreover, Bernanke’s position that these price increases will prove transitory are contradicted by the continued fall in the value of the dollar on commodity and foreign exchange markets. Gold prices had begun to stabilize near $1400 an ounce in the first quarter. But, the past several weeks have seen price increases accelerate again, taking the price of gold to above $1500 an ounce and oil prices north of $110 a barrel.
Second, I sincerely doubt that Bernanke will be able to keep his promise to control inflation quickly once he finally admits it has arrived. The reason is a fundamental flaw in the traditional thinking at the Fed which equates an increase in the Fed Funds rate, per se, with an inflation reducing “tightening” of monetary policy.
In a breakthrough study, Dr. John P. Hussman of the Hussman Funds points out that an increase in the Fed Funds rate alone would increase, not decrease, inflationary pressures. His study documents that a higher Fed Funds rate would increase the velocity of the monetary base. An increase in velocity means that the same monetary base would support a higher level of nominal GDP. The only way to produce a higher level of nominal GDP with the same level of real output is through an increase in the price level – in other words, more inflation
In a chilling warning, Hussman writes:
“In order to achieve a non-inflationary increase in yields even to 0.25%, the Fed will have to reverse the entire amount of asset purchases it has engaged in under QE2. Indeed, the last time we observed Treasury bill yields at 0.25%, the monetary base was well under $2 trillion.”
The Fed may be able to mitigate the need to shrink its balance sheet by increasing the interest rates it pays on bank reserves – something it did not do in the past. Those higher rates would encourage banks to maintain their excess reserves at the Fed, thereby slowing the increase in velocity associated with a higher Fed Funds rate. But, for the Fed to avoid making an inflationary mistake requires Bernanke and his colleagues to get it exactly right, even as a growing number of people become less willing to give him the benefit of the doubt.
The fundamental challenge that Bernanke now faces is this: Nothing stands behind the value of the dollar other than people’s willingness to trust its worth. Reputations – and trust — are built by making and keeping promises. They can take years to develop, but only a short time to destroy.
Once promises begin to be broken, reputations and trust begin to decline and people begin to “hedge their bets.” At some moment, a tipping point is reached where the individual or company is no longer trusted and their reputation is lost.
Breaking both the promise that inflation is under control, and the promise to control inflation once it has broken out, will not only undercut the Fed’s reputation, it will also undermine trust in the future buying power of the dollar.
As people trust the dollar less, they will drive prices higher as they seek to rid themselves of the falling currency. Lenders will demand higher interest rates to protect themselves against the uncertainty of its future value. Rising inflation and interest rates feed the distrust, potentially producing a vicious circle of accelerating inflation and interest rates.
The last time the Fed destroyed trust in the dollar was the 1970s. The end result was double-digit inflation, record high interest rates, a global run on – and near collapse – of the dollar. How close we are to a re-run of this scenario will be determined not only by what Bernanke says during his press conference, but also by the skillful actions that he and his colleagues take to demonstrate to millions of people all over the world that the dollar is a currency worthy of their trust.