Bernanke’s Press Conference Dished Out Plenty Of BS

May 2011

Federal Reserve Chairman Ben Bernanke held the first-ever news conference by a Federal Reserve Chairman. The move was an obvious effort to calm financial markets after a string of unsettling news. Some of the questions asked during this Q&A session were actually quite good; others were merely softballs. Financial markets generally took the bait, and all appears to be calm again. However, as we summarize in this article, this calm reaction is entirely incorrect.

Chairman Bernanke helped the expected boredom by saying pretty much nothing. News about the Federal Reserve usually does not get mainline America stirring, and this news conference was no exception. But, a lot could and should have been said, as there are plenty of challenges to be addressed.

Here is the recent news that triggered the news conference. One of these events involves the S&P negative outlook on the U.S. debt rating. The S&P outlook generated the following from Mr. Bernanke:

"In one sense S&P's action didn't really tell us anything because everyone who reads the newspaper knows that the United States has a very serious long-term fiscal problem. That being said, I hope that this event will provide at least one more incentive for Congress and the administration to address this problem. I think it's the most important economic problem, at least in the long run, that the United States faces. We currently have a fiscal deficit that is simply not sustainable over the longer term, and if it's not addressed it will have significant consequences for financial stability, for economic growth, and for our standard of living... To the extent that the S&P action goads response, that's constructive."

Quantitative easing (QE) is an unconventional monetary policy used by the Federal Reserve to stimulate the economy. Under QE, the Federal Reserve (aka Fed) buys government bonds with new money that the central bank creates (i.e., prints). This increases the money supply and the reserves within the banking system. This purchasing raises the prices of the Treasury instruments bought, which in turn lowers the yield. In November 2008, the Fed initially announced a $600 billion QE program, but then increased that to $1.8 trillion four months later. In November 2010, the Fed announced a second round of bond purchases (called QE2), totaling $600 billion in long-term Treasuries over the next eight months, plus $250 billion to $300 billion reinvested in Treasuries with the proceeds of its earlier investments.

This dramatic increase in the money supply predictably leads to inflation. Regarding this program of printing money, Bernanke predictably said that the Fed’s program was successful, and not risky. Specifically:

“We were very clear from the beginning while we thought this was an important step and that it was at an important time when we were all worried about a double dip and we were worried about deflation, we were very clear that this was not going to be a panacea. That it was only going to turn the economy in the right direction and indeed we published some analytics which gave job creation numbers which were significant, but not, certainly not enough to completely solve the enormous jobs problem that we have.

So again, relative to what we expected, anticipated, I think the program was successful. Why not do more? Again, this was similar to the question I received earlier. The trade-offs are getting less attractive at point. Inflation has gotten higher. Inflation expectations are a bit higher.

It is not clear that we can get substantial improvements in payrolls without some additional inflation risk.”

Unfortunately, inflation and the risk that inflation will increase, is a far greater problem than the Fed is admitting. Although not the major problem, the Fed focuses all of its commentary on the “core” Consumer Price Index (CPI). The core CPI ignores food and energy prices, both of which have been increasing more rapidly than other prices. Assuming the core CPI is the correct starting point and it were calculated consistently, Bernanke might be justified in not being concerned about inflation. According to last month’s U.S. Department of Labor’s Bureau of Labor Statistics (BLS) report, the all-urban consumer price index (CPI-U) was up only 2.7 percent in March relative to the same month last year. Once you strip out the costs of food and energy, the core CPI is just 1.2%.

So why are Americans feeling their wallets pinched so much lately at the gas and food stores when the CPI-U is relatively low? The answer lies in the government’s statistics. According to the BLS, “the CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services”. Thus, the CPI is designed to measure the cost of a fixed basket of goods, comparing apples to apples to accurately measure (i) returns on investments relative to inflation, and (ii) the standard of living one can afford on a given income relative to inflation. However, since the late 1970s, the BLS changed how it measures the CPI “basket” 24 times.

By substituting product and quality improvements, the inflation rate can be artificially decreased. For example, if the price of steak increased “too much”, the price of hamburger or something “comparable” would be substituted into the CPI. As a result, the CPI has changed from measuring inflation relative to a given standard of living to measuring inflation relative to a declining standard of living. If the original methods (those prior to the late 1970’s) were still used today, today’s CPI would be approximately 10 percent. The chart below shows the CPI-U (red line) as measured by the BLS’s continually changing measurements and the alternate CPI (blue line) as measured using BLS’s “original” method.

The above chart shows that Americans’ are justified in feeling that prices are rising and inflation is actually already here. Although Chairman Bernanke has been consistent in his inflation message, most would prefer the truth over consistency. In his March 1, 2011 Congressional testimony, the Chairman said he did not view increases in commodity prices as a problem, in part, because

“Inflation expectations … [are] quite well anchored, which helps keep inflation stable, even if there are temporary movements coming from commodity prices.”

Among other reasons, the CPI is important because it is used by the Fed to justify its monetary policy. Mr. Bernanke’s answer to a pointed question about the Fed’s monetary policies causing inflation expectations was dubious at best.

“Well, we view our monetary policies as being not that different from ordinary monetary policy. It's true that we used some different tools, but those tools are operating through financial conditions and we have a lot of experience understanding how financial conditions, changes in interest rates changes in stock rates, so on, how they affect the economy, growth, et cetera. We are monitoring the state of the economy, watching the evolving outlook and our intention as is always the case is to tighten policy at the appropriate time to ensure that inflation remains well controlled; that we meet that part of our mandate while doing the best we can to ensure also that we have a stable economy and a sustainable recovery in the labor market. So the problem is the same one that Central Banks always face, which is choosing the appropriate path of tightening at the appropriate stage of the recovery. It's difficult to get it exactly right, but we have a lot of experience in terms of what are the considerations and the economics that underlie those decisions. So we anticipate that we will tighten it at the right time and that we will thereby allow the recovery to continue and allow the economy to return to a more normal configuration; at the same time keeping inflation low and stable.” [Emphasis added]

The Fed reacted to the recent economic downturn by (i) lowering short-term interest rates to exceptional near zero rates and (ii) launching the experimental and controversial QE to stimulate the economy. The above statement from Mr. Bernanke that the Fed’s recent monetary policies are “not that different from ordinary monetary policy” is silly, and entirely contradicted by the Fed’s own data available on its website. A more honest presentation by Mr. Bernanke would have discussed the following four charts from the Fed’s own website. In all of the following four charts, the shaded areas indicate U.S. recessions.

1. Recent U.S. government interest rates are near zero, which is clearly abnormal. See the following Chart 1.

   Chart 1

   

2. Growth in the money supply has always led to higher inflation. Nothing has occurred in economics to indicate that this maxim no longer applies. Because of the Fed’s QE program, the increase in the monetary base (the amount of money in the economy) is unprecedented. See the following Chart 2.

   Chart 2

   

3. As shown in the following Chart 3, banks are holding unprecedented amounts of the excess reserves, and not loaning it. Much (but not all) of these excess reserves come from the increased money supply, as shown in Chart 2.

   Chart 3

   

4. The large amount of held money decreases the velocity of money stock. Money velocity refers to how quickly a dollar changes hands – for example, when you deposit a dollar into your checking or savings account, your bank can then lend that dollar out to ten other people, essentially creating ten more dollars out of your one dollar deposit. Today’s low velocity, as shown in chart 4, is a way of examining the impact of the data in Chart 3.

   

The Fed’s QE2 program is expected to end in June 2010. Mr. Bernanke stated that the QE2 program will not be extended. This raises the question of what will happen when the federal government stops being the largest purchaser of its own debt. PIMCO’s Bill Gross shows the unprecedented amount of our own debt the Fed owns and is purchasing, as follows:

The desirability of U.S. bonds depends in part upon how well the U.S. government and its finances are operated. The U.S. record $14.2 trillion debt (and still counting), and $1.4 trillion deficit (and still counting) are relevant on this point. As the above chart indicates, once the Fed stops its purchases via QE2 in June 2011, no one knows with certainty who is going to buy U.S. bonds. In order to attract other buyers, the interest rate paid will have to increase. But, according to Mr. Bernanke, this is all “not that different from ordinary monetary policy”.

In contrast to Mr. Bernanke’s calm, here are some of the messages that the above charts convey:

1. The Fed’s current policy has practically eliminated the interest rate on overnight government borrowings, known as the federal funds rate. The excess reserves held by banks are not being used for loans, as the Fed intended. Instead, the banks are using the funds to purchase short-term Treasuries or other safe short-term instruments. The spread earned by the banks may not sound large, but this represents a nearly riskless way of investing the unprecedented reserves and taking advantage of the Fed’s loose monetary policies. This giveaway of billions to U.S. banks on behalf of the U.S. taxpayer is appalling.
2. Although the QE programs have generally been ineffective (except as a government giveaway to those taking advantage of the federal funds rate), they have not yet increased the supply of money actually being employed in the economy as much as might have otherwise occurred. At some point, the banks will start lending at “normal” rates again, and the velocity of money will increase. Before this occurs, to avoid inflation becoming even larger than what is already in process, the Fed should start to unwind its QE program and raise the federal funds rate.
3. The Fed has practically tripled the money supply. Even if the excess reserves were entirely eliminated by a partial unwinding of the QE programs, there will still have been an enormous increase in the money supply. This will cause inflation, which we are already starting to experience.

Mr. Bernanke’s news conference included the following exchange regarding oil price inflation:

“Q: Many Americans are upset that gasoline prices are rising so fast and food prices are also going up. Can you talk about whether there's anything that the Fed can or should do about that? Can you also elaborate on the increase that we have seen in the inflation forecasts that the Fed put out today?

A: …Our interpretation of the increase in gas prices is the economist basic mantra of supply and demand… There's not much that the Federal Reserve can do about gas prices per se. At least not without derailing growth entirely, which is certainly not the right way to go. After all, the Fed can't create more oil. … What we can do is basically try to keep higher gas prices from passing into other prices and wages throughout the economy and creating a broader inflation which will be much more difficult to extinguish. Again our view is that most likely, of course we didn't know for sure but we will be watching carefully, is that gas prices will not continue to rise at the recent pace. As they stabilize or even come down if the situation stabilizes in the Middle East, that will provide relief on the inflation front, but we have to watch it very carefully.”

While the Fed cannot create more oil, it certainly does have something to do with the prices Americans pay. Some of the recent oil price increase occurs because of the weak U.S. dollar, which in turn is caused by the weak demand for the U.S. dollar. The weak U.S. dollar is certainly affected by low U.S. interest rates, particularly when compared to inflation expectations by these same investors. On all of these points, the Fed can do quite a bit. By hitting the money print button for practically the last two years, the Fed caused much of the price increases that are now starting. Instead of oil prices that will “stabilize or even come down”, this author predicts that, absent substantial changes in U.S. monetary policy, we will wish for the better times when we could purchase gas for only $4 a gallon.

Fulcrum Inquiry performs economic analysis for litigation, forensic accounting, and business valuations.