A Massive Wealth Transfer

The Fed's Policy of Creating Inflation

If once [the people] become inattentive to the public affairs, you and I, and Congress and Assemblies, Judges and Governors, shall all become wolves. It seems to be the law of our general nature, in spite of individual exceptions.
— Thomas Jefferson (1743-1826), 3rd US President

If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered.
— Thomas Jefferson

[Corruption in high places would follow as] all wealth is aggregated in a few hands and the Republic is destroyed.
— Abraham Lincoln (1809-1865), American 16th US President (1861-65)

When plunder becomes a way of life for a group of men living together in society, they create for themselves, in the course of time, a legal system that authorizes it and a moral code that glorifies it.
Frederic Bastiat (1801-1850), French economist

Inflation made here in the United States is very, very low.
— Ben Bernanke, Fed Chairman, Thursday, February 10, 2011

Let us begin with some macroeconomic indicators of reference.

In October 2010, the world value of total production (all Gross Domestic Products or GDPs) was estimated to be $61.96 trillion U.S. dollars at current nominal prices. The U.S.GDP was estimated at $16.11 trillion or 26 % of world GDP.

The two largest financial markets in terms of trading values are the global foreign exchange market (all currency markets) that has an average daily turnover in global foreign exchange transactions of about $4 trillion per day, and the privately-traded and mostly unregulated world derivatives market (all the derivatives markets) whose total world outstanding contracts has been estimated by the Bank for International Settlements in Switzerland to have a notional or face value of about $791 trillion in 2010.

In terms of real wealth, however, the two most important financial markets are the world bond market and the world stock market. In 2009, for example, the global bond market had an outstanding value of $US 91 trillion, with the U.S. bond market, at a value of $US 35.5 trillion, being the largest domestic bond market. In mid-2010, the global equity market capitalization on regulated exchanges was estimated at $US 54.9 trillion, with the U.S. stock market having a value of some $US 19.8 trillion.

With such a large amount of financial assets, it is understandable that shifts in prices and interest rates have important effects on each market. If long-term interest rates go up, the nominal value of bonds goes down, and conversely, when interest rates decline, bond prices go up. As for stocks, many factors, such as company earnings, future profit prospects and inflation expectations, as well as political and taxation considerations, can influence their value. However, in general, they tend to fare better when short-term interest rates are low rather than high.

Sometimes, these two important financial markets move up together, especially in an environment of general disinflation, when interest rates tend to decline. They also tend to decline in tandem when real interest rates are on the rise, both bond prices and stock prices are then falling.

Sometimes, however, they can move in different directions, especially in the early phase of an inflationary period, such unexpected inflation being good for the stock market but bad for the bond market. Since last fall, this has been case, with the bond market falling and the stock market rising. The question is how long this decoupling can last.

And how does the Fed’s monetary policy fit into such an environment of oncoming inflation, and what should the Fed do?

Last November 3rd, the day after the 2010 mid-term elections, the Bernanke Fed announced that it will be embarking on a second round of quantitative easing (QE2), a fancy word for printing new money in exchange for government bonds—in other words, monetizing the public debt. It seems that Chairman Bernanke and the Fed board felt that months of lending to the large American banks trillions of dollars at close to zero interest rate, while paying them 0.25 percent to keep their excess reserves on its books, was not enough. They announced that the Fed would buy $600 billion-worth of additional Treasury bonds until June 2011, while reinvesting some $300 billion of principal payments from its portfolio holdings of mortgage-backed securities.

In doing so, the Fed professed to follow two somewhat interrelated objectives: 1) to lower long-term real interest rates in order to stimulate economic activity and create employment; and 2) to simultaneously raise inflation expectations in order to avoid the effect of deflation on the U.S. debt-leveraged economy. It should be remembered that from 1913 to 1977, the Fed had only one objective to pursue, i.e. price stability. Currently, however, the Fed has officially a double mandate. As a matter of fact, since 1977, the amended Federal Reserve Act of 1913 stipulates that the U.S. central bank should set its monetary policy in order to promote employment while maintaining price stability. It says that the Fed should promote “maximum employment, stable prices, and moderate long-term interest rates.”

Of course, a central bank in a fiat currency system can always create inflation through monetary policy and its printing press, but, in a market economy, it has little direct influence on job creation and on long-term interest rates. Employment depends on investments, innovation and market opportunities at home and abroad, while long-term interest rates depend on the amount of savings available, on investment demand and on long-term inflation expectations, all factors that are more or less out of the reach of a central bank. It is easy to delude oneself into thinking otherwise, but that’s the reality.

What the Fed can do with certainty, however, is to create inflation by expanding the monetary base and the money supply; it can also reign in inflation by draining liquidity from the system. If it goes overboard one way or the other, it can also create asset price bubbles by maintaining its managed short-run interest rates too low for too long, or it can create a credit crunch by putting the brakes too hard on credit creation, usually in a haste to correct its previous mistake.

These short-term gyrations in monetary policy are very destabilizing to the real economy, sometimes creating a temporary boom; sometimes precipitating an economic downturn. They are also accompanied by massive shifts of wealth between creditors and debtors.

In the first instance, when the Fed (or any central bank for that matter) creates too much money by buying financial assets and writing checks on itself, inflation and inflation expectations ensue. This pushes short-term interest rates down and long-term interest rates up (a steepening of the yield curve) and the price of long bonds goes down, with the effect of imposing an inflation tax on all the holders of fiat dollars. This inflation tax results in a transfer of wealth between unsuspecting dollar holders and bond holders who see the real value of their holdings go down, while net debtors and stock owners see their real debt load being reduced by inflation and the value of most shares in the stock market going up.

In the second instance, the reverse can happen if the economy is starved of liquidity: the yield curve inverts with short-run interest rates moving way up as compared to long-term interest rates. A stock market crash and an economic recession generally follow.

That’s pretty much what the Fed has been doing over its nearly 100 years of existence, keeping short-run interest rates too low for too long, creating unsustainable asset bubbles, and then applying the monetary brakes to kill inflation expectations that it has created on its own. Sometimes, the Fed has maintained price stability and the value of the U.S. dollar; but at other times, it has willingly acted to destroy the purchasing power of the dollar by printing too much of it.

As a general principle, if inflation expectations increase faster than nominal long-term interest rates, real interest rates, i.e. the real cost of capital for investors and home buyers, would decline and this would, hopefully, stimulate economic activity and employment.

Unfortunately for the Fed, its Nov. 3rd announcement translated into an important loss of confidence in its ability to design and pursue an appropriate monetary policy and was immediately decried by other central banks and by America’s biggest creditor, China, as a blatant attempt to generate and export inflation. Bond prices began immediately to fall and bond yields to rise. It seems that bondholders began selling longer-term Treasuries at a faster rate than the Fed could buy them.

Chairman Ben Bernanke and his board seem to have forgotten that the United States is now a debtor nation, not a creditor nation. A creditor nation could get away with an outspoken policy of creating inflation—but not a debtor nation. In 2010 alone, the U.S. registered another half a trillion-dollar trade deficit with the rest of the world. This has to be financed, and it is done with foreign borrowings. To a large extent, foreign creditors now decide the final outcome of American monetary policy.

The 10-year Treasury yield, which hit a low at 2.40 percent in October 2010, was at 2.63 percent the day before the Fed’s announcement on November 2, 2010. As it turned out, it closed at 3.64 on Friday February 11, after hitting a high of 3.75 percent on February 8. The same is true of the 30-year Treasury yield that hit a high of 4.76 percent on February 8, thus approaching the dangerous threshold of 4.90 percent. The latter stood at 3.93 percent on Nov. 2, 2010.

Obviously, the Fed’s ultra loose monetary policy has backfired. Its intended policy of printing money in excess of what the economy demands has resulted in raising real long-term interest rates, not lowering them. Indeed, with long-term nominal rates on the rise while inflation will take many months to surface, the immediate effect of the Fed’s November announcement was to raise real long-term Treasury rates, not to lower them. Mortgage rates are also on the rise, threatening to postpone the long anticipated recovery in the housing market.

It is certainly possible that we are entering a period when the already observed rise in real interest rates can derail the stock market rally that has been in force since early March 2009. Later on, however, a slowdown in the economy coupled with fiscal compressions can be expected to push long-term rates down again. Such a roller-coaster path for interest rates is not very helpful.

The current Fed board seems to believe that the Fed is more than a central bank, that it is a sort of a government unto itself that can both control monetary conditions and solve the structural problems in the real economy at the same time, irrespective of what the rest of the world thinks. This would seem to be most unrealistic. Perhaps a dose of humility would be salutary at this time, before irreparable damage is done.

Rodrigue Tremblay is professor emeritus of economics at the University of Montreal and author of the book The New American Empire. He can be reached at: rodrigue.tremblay@yahoo.com. Read other articles by Rodrigue, or visit Rodrigue's website.

5 comments on this article so far ...

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  1. bozh said on February 15th, 2011 at 11:35am #

    we have been ruled by mafia for millennia. jefferson, lincoln either didn’t know this or if the did know, decided to obnubilate it with such quotes as the ones in this piece.

    neither of those quotes offer an elucidation. in fact, lincoln and jefferson complexify the simplicity i just posited: we r ruled by mafia.

    it appears a serious distort of reality to say: when people get inattentive to what some people do, the people in power wld become wolves.

    no person [if enlightened] wld stop paying attention to herhis affairs; i.e., running the country.
    but once a child is rendered blind by clerico-noble class of life, of course, s/he stops inquiring what goes on in herhis name.

    from this, one may conclude s’m event already preceded inattentiveness of people. the event in question consists of people rendered landless, voiceless; frightened to death, etc.
    jefferson quote is a locus classicus for blaming the victims and not the usurpers of fairness.

    as for lincoln’s: corruption in high places wld destroy the republic, this too falls in the category of a complexity. in add’n, he only concludes. the conclusion being a very vague complexity.

    corruption in high places hurts mostly people in low places and thus poor people’s republic, but may not ever destroy rich people’s republic.

    as long as the rich people’s republic encircles the world with wmd, warships, surveillance, bases, etc., republic is even now expanding and will expand more.
    But then all presidents spoke with a forked tongue or covered all bases so that they cld forever rest in peace

    after all, they all went to church and may have believed in hell; however, did not know that the hell had by then cooled dwn sufficiently to suit even hitler, let alone lincoln, adams, johnson, et al. tnx

  2. kanomi said on February 15th, 2011 at 12:31pm #

    There’s no doubt reckless inflation through monetary creation remains a hidden tax on all savers, but it seems to me, as we careen towards financial endgame, that the preferred method of theft is now simply stealing directly from through the Treasury ala TARP and whatever other criminal schemes the banks can devise.

    Load up on junk assets, and force the government through your controlled politicians and appointees to make you good.

    Now that the housing market has been gamed, it seems they are going after cities and states. Wouldn’t be surprised at all if JPM, GS, etc. are all leveraged short municipal bonds.

  3. Don Hawkins said on February 15th, 2011 at 2:30pm #

    JPM, GS, etc. are all leveraged short municipal bonds ok then I can help build a Pyramid with a dollar sign running through it and let’s keep it simple we write Ponzi scheme on the dollar sign. Painting is not my best skill because the pyramid to draw the Arctic with ice melting could send a message. I have all the tools needed and yes where to build it well who lives in New York City that could have an idea or two and paint’s. Flatbed truck remember the right to assembly free speech money oh dear I don’t have any make it pretty much month to month so who in New York who has money would like to join us anybody have any ideas a rally in front of the stock exchange then maybe Fox New’s and how far is to the Goldman building on the waterfront ? Always’ good to have people at a rally who know’s the group’s in New York or how to get the word out cell phones, computers, text messages. Speakers I know someone that lives in the new York area a scientist and a good one. Ok then how do we get started with the 2020 party in 2011.

  4. Don Hawkins said on February 15th, 2011 at 3:35pm #

    Freedom of assembly, the individual right to come together and collectively express, promote, pursue and defend common interests and it sure seems in 2011 the common interest is our very survival. I will say it again probably this summer and next will make that very clear unless of course you go with the message is the medium and or played the back nine one two many times.

  5. mary said on February 16th, 2011 at 5:31am #

    Madoff states the obvious.

    Bernard Madoff says banks knew of Ponzi scheme

    Convicted fraudster Bernard Madoff has blamed others for being “complicit” in his scheme, which fleeced investors of billions of dollars.

    Madoff is serving 150 years in jail in the US for a $65bn (£40bn) fraud which deprived thousands of investors of their savings.

    Now he has told the New York Times a variety of banks and hedge funds “had to know” about his Ponzi scheme.

    Such schemes pay out using new investor money rather than from any profits.

    Madoff claimed banks and hedge funds who had dealings with his investment advisory firm showed a “willful blindness” toward his activities.

    He also alleged they failed to examine discrepancies between his regulatory filings and other information.

    “But the attitude was sort of, ‘If you’re doing something wrong, we don’t want to know’,” he said.

    However, he did not assert that any specific bank or hedge fund knew about or was an accomplice in his Ponzi scheme.

    His scheme had been running since the early 1990s.

    It unravelled when Madoff’s investors, hit by the economic downturn, tried to withdraw about $7bn, but he could not produce the money.

    Madoff also told the New York Times that his family knew nothing about his crimes.