"If the people only understood the rank injustice of our money and banking system there would be a revolution before morning." - President Andrew Jackson.
The central bank consistently misleads us:
- Federal Reserve Presidents continue to tell us that policy is framed by the false idea that higher growth leads to higher inflation.
- The Chairman of the Federal Reserve openly contradicts himself on money supply.
- The Federal Reserve emphasizes price indices as an inflation indicator, when they are in reality only a manipulated symptom of correctly defined inflation.
Once we have exposed these Federal Reserve myths for what they are, we can more clearly see the real purpose and context of this institution. If investors do not understand what the Federal Reserve really is and what it does what chance of long term success do they actually have?
Higher growth leads to higher inflation? No!
First of all, take a look at our experience of these two economic variables, Real GDP Growth versus inflation, over several decades since 1962.
The best fit regression line makes the case that if anything higher growth correlates with lower inflation!
Reinforcing this evidence is basic economic theory. It should be intuitively obvious that economic growth involves the production of more goods and services. So without any change in money supply then the same amount of money is chasing more goods than before. This means that prices should clearly fall. This rationale is also clearly imbedded in the famous ?Monetary Exchange Equation?:
Real GDP x GDP price index = Money Supply x Money Velocity
Holding the right hand side of the equation constant, it is clear that an increase in growth is exactly offset by a fall in prices. So far so good, but how on earth can Federal Reserve Presidents have got something so simple and so obvious, so wrong?
Take a look at some recent comments. On Monday 6th November Michael Moskow, President of the Federal Reserve Bank of Chicago, was quoted as saying: "The risk of inflation remaining too high is greater than the risk of growth being too low, thus some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability..." Then, on Tuesday, the Financial Times quoted Federal Reserve Bank of Richmond President Jeffrey Lacker as saying that the central bank had not been clear enough regarding "how it would respond to the pass-through of energy cost increases to consumers in the shape of higher prices", and that "...there is now a bigger risk of rising inflation than of slower growth...".
Both Moskow and Lacker reinforced the notion that there is some sort of trade-off between economic growth and inflationary pressures. As this strikes at the core of the Fed's monetary policy and its implementation, shouldn't some one point out that this basic theory looks way off base?
Is money supply important?
Other statements seem equally bizarre. On November 11th, 2006, in response the head of the European Central Banks? advocacy of money supply as an important policy tool, Ben Bernanke was quoted in the Financial Times as downplaying its? role, saying that a heavy reliance on money supply as a measure ?would seem to be unwise in the US context?. As if geography somehow makes a difference. Yet in November 2002 Bernanke authored a Federal Reserve paper ?Deflation: Making sure ?It? Doesn't Happen Here?. Here he argued that the Federal Reserve could use virtually limitless money supply to avoid deflation. In this instance, he clearly argued it was an invaluable and indispensable mechanism. Either money supply is relevant or it is not. Bernanke can not have it both ways.
How do you define inflation?
Perhaps the Federal Reserve wants to avoid any discussion of money supply altogether, and keep it as their own little secret. They continue to talk about inflation as being measurable by one or other of many inaccurate and faulty price indices, which can all be conveniently adjusted or rebased. However, this just distracts attention away from what inflation really is. Simply put the correct definition of inflation is the increase in the quantity of money and money substitutes. This also may not be easy to measure, but at least it is the correct definition.
By using price indices for presentation purposes, they can conveniently ignore massive inflationary signals from asset prices such as gold, house prices and the stock market.
What's going on here?
These people are not stupid so why are their statements so strange and misleading? Anyone might think they are throwing up a smokescreen. Now you are getting closer.
To make any sense of how the central bank works, you need to understand the real purpose and objectives of the Federal Reserve. It is only in this context that you will be able to understand how it operates. Their purpose is to promote inflation through manipulation of their two policy instruments, which are interest rates and the money supply. Policy statements have to disguise this because the central bank's ability to guarantee inflation is only possible so long as most people do not understand this is what they are doing. This is why so many of their statements sound so concerned about inflation risks. They have to play the part of custodians of the integrity and value of the currency. So how have they done?
The chart below shows the 200 year history of the purchasing power of the dollar, both in times when it was a fiat currency (in dotted lines), and in periods when it was on the gold standard (solid line).
The purchasing power of the dollar has fallen by over 90% since the Federal Reserve Act of 1913. Prior to this the dollar's value was stable for over a hundred years. The chart also shows that the devaluation of the dollar accelerated dramatically under the fiat money system.
It is not hard to show that Federal Reserve policy statements are typically confusing, contradictory, and misleading. The real reason for this is that the central bank has to disguise its real purpose and objectives. It is only in this context that you will be able to understand how the bank operates. Their purpose is to promote inflation through manipulation of their two policy instruments, which are interest rates and the money supply. Their record shows they have been very successful as inflation has been substantially higher since the Federal Reserve was established. However, policy statements have to disguise this because the central bank's ability to guarantee inflation is only possible so long as most people do not understand this is what they are doing.
Together with fiat money, central banks have enormous power to control the economy, and have many partners who can benefit from this monetary system. Government spending becomes much easier to finance, and the banking system can grow its balance sheets at a much more rapid pace, safe in the knowledge that the central bank will defend them from the devastating consequences of falling nominal prices.
However, this does not benefit everyone. Those who do not understand that the currency is manipulated and often undermined run a high risk of losing real purchasing power and may find it much harder to grow their real wealth. Investors need to understand that most Federal Reserve statements are bound to be misleading as they are designed to manage inflation expectations and other propaganda purposes, not to enlighten us. It is no wonder, therefore, that most people find financial markets and economics so confusing. They are purposefully being misled by the central banks, and their allies.
An accurate interpretation of monetary policy has to look through this smokescreen to determine true market effects and developments.