Page 4 of
5 THE ROAD TO
HYPERINFLATION, Part 2 A failure of central
banking By Henry C K Liu
each bank was independent and enjoyed no
systemic liquidity protection. These problems were
more severe in the South and the West, where
farmers were frequently victimized by bank crises
often created by Northeastern money trusts to
exploit the seasonal needs of farmers for loans.
To this day, the Fed operates a seasonal discount
rate to handle this problem of farm credit.
The Northeastern money elite in 1913
wanted a central bank controlled by bankers, along
Hamiltonian lines, but internationalist rather
than nationalist to make the US a global financial
powerhouse. But the Wilson
administration, faithful to Jacksonian tradition
despite political debts to the moneyed elite,
insisted that banking must remain decentralized,
away from the control of Northeastern money
trusts, and control must belong to the national
government, not to private financiers with
international links, despite the internationalist
outlook of Wilson.
Twelve Federal Reserve
Banks were set up in different regions across the
country, while supervision of the whole system was
entrusted to a Federal Reserve Board, consisting
of the Treasury secretary, the comptroller of the
currency and five other members appointed by the
president for 10-year terms. All nationally
chartered banks were required and state-chartered
banks were invited to be members of the new
system. All private banknotes were to be replaced
by Federal Reserve notes, exchangeable at regional
Federal Reserve Banks not only for bonds or gold
but also for top-rated commercial paper, with the
hope of causing the money supply to expand and
contract along with the volume of business.
With the reserves of all banks deposited
with the Federal Reserve, systemic stability was
supposed to be assured. Unfortunately, systemic
stability has been an elusive objective of the Fed
throughout its history of 94 years, largely due to
the Fed fixation on the market rather than the
economy. To the Fed's thinking, even today, the
market drives the economy, not the other way
around. Take care of the market, and the economy
will take care of itself. Unfortunately for the
Fed, this fixation has been proven wrong
throughout history. The market is but a gauge on
the economy. If the economy is running empty,
fixing the gauge does not fix the real problem.
Fed's ineffectual response to 2007
crisis The equity market's decade-long
joyride on the Fed's easy money policy came
abruptly to an end in August 2007. In response to
the outbreak of the credit crisis, which the Fed
adamantly but mistakenly thought to be
containable, the Federal Open Market Committee
(FOMC) on August 17 lowered the discount rate 50
basis points to 5.75% but kept the Fed Funds rate
target unchanged at 5.25%. As the credit market
continued to deteriorate, the FOMC was then forced
on September 18 to again lower the discount rate
another 50 basis point to 5.25% and the fed funds
rate target 50 basis points to 4.75%.
Six
weeks later, on October 31, the FOMC, trying to
correct a massive credit market failure and to
inject liquidity into the severely distressed
banking system, lowered the discount rate another
25 basis points to 5% and the fed funds rate
target another 25 basis points to 4.5%.
In
an accompanying statement on October 31, the Fed
continued to paint a comforting picture that
economic growth was solid in the third quarter of
2007, and strains in financial markets had eased
somewhat on balance since August. However, the Fed
qualified its denial by saying: "The pace of
economic expansion will likely slow in the near
term, partly reflecting the intensification of the
housing correction." That action, combined with
the policy action taken in September, was expected
"to help forestall some of the adverse effects on
the broader economy that might otherwise arise
from the disruptions in financial markets and
promote moderate growth over time."
By
November 27, the DJIA intraday low had dropped
1,000 points to 12,711.98 from the October 31
intraday low of 13,711.59, having reached an
intraday high of 14.168.51 on October 12. Market
anticipation of more Fed interest rate cuts to
lift the market pushed the DJIA back up to
13,727.03 by December 11, on which day a panicked
Fed again lowered the discount rate by 25 basis
points to 4.75% and the fed funds rate target by
25 basis points to 4.25%. A disappointed market,
which had expected a 50 basis point, cut saw the
DJIA drop 295 points to close at 13,432.77.
The Fed was reduced to playing short-term
yo-yo with interest rates driven by the stock
market at the expense of its mandate to guard
against long-term inflation. The Bureau of Labor
Statistics (BLS) reported that the Headline
Consumer Price Index (HCPI) for November 2007 was
4.3% higher than November 2006, and 5 basis points
higher than the Fed Funds rate target of 4.25%.
Cuts put downward pressure on
dollar The Fed's interest rate actions put
continued downward pressure on the both the
exchange rate and the real purchasing power of the
dollar, thus further increasing inflation in
import and domestic product prices, especially oil
for which the US is both an importer and a
producer. January oil price futures for April 2008
delivery jumped $1.35, to $88.75 a barrel. Since
April 2006, core inflation has remained within the
2.2 - 2.3% range, higher than the unofficial
targeted inflation rate of 1.6% to 1.9%. This
hampers the Fed’s ability to lower interest rates
further without unleashing inflation down the
road.
Core and headline
inflation For the typical household, the
total or headline inflation, which includes
volatile food and energy price components, is what
counts because headline inflation measures the
rate at which the cost of living is rising against
relatively stagnant household income. A high
headline inflation rate relative to income growth
causes household standard of living to fall.
For the purpose of calibrating monetary
policy, however, the Fed focuses on the core rate
of inflation: the total excluding food and energy
prices, on account that the core is less volatile
and is deemed a better reflection of the interplay
of supply and demand in domestic product markets.
Thus, the core traditionally is a better gauge of
the underlying rate of inflation in the absence of
external supply shocks.
By contrast, food
and energy prices can be extremely volatile from
month to month due to temporary supply disruptions
related to weather or to political crises. In
those instances, headline inflation tends to be
less representative of the underlying rate of
inflation. Headline inflation has relatively minor
macroeconomic impact; it tends to shift revenue
from one sector to another. When oil prices rise,
oil company revenue increases while consumer
expenditure rises. The net result is a higher GDP
figure but not necessarily a larger economy. Yet
this rationale is less operative in the current
situation, where both energy and food prices have
risen dramatically with volatility along an upward
curve and imported oil payment has become a major
item in the US trade deficit.
The
historical record of the US economy is that
headline and core inflation have averaged about
the same over the long run. Over the past two
decades, annual inflation as measured by the
Personal Consumption Expenditure (PCE) deflator
averaged 2.6%, while price increases as measured
by the core PCE deflator averaged 2.5%. Data from
the past 10 years pose a challenge to the
rationale for focusing on the core. Over that
period, crude oil prices have been volatile,
rising from below $10 per barrel in early 2000 to
near $100 currently. Food prices and that of other
commodities are also rising at an above normal
rate.
Such rises are no longer expected to
be temporary. They tend to stay high for long
periods because of the long-term decline of the
dollar, which has become the main factor behind
global hyperinflation trends. Thus even if the
headline inflation rate eventually moderates from
month to month, prices can stay high relative to
income. Inflation readings from price levels
independent of income levels are not informative
on the health of the economy.
Readings on
core inflation were interpreted by the Fed as
having improved modestly in October 2007, but
increases in energy and commodity prices in the
second half of the year, among other factors,
might put "renewed upward pressure on inflation".
In that context, the FOMC judged that "some
inflation risks remained, and it would continue to
monitor inflation developments carefully." The
FOMC, after its October 31 action, judged "the
upside risks to inflation roughly balance the
downside risks to growth." The committee would
"continue to assess the effects of financial and
other developments on economic prospects and will
act as needed to foster price stability and
sustainable economic growth".
The single
dissenting vote against the FOMC easing action was
Thomas M Hoenig, who argued for no cuts in the
federal funds rate at the meeting. In a related
action, the Board of Governors unanimously
approved a 25-basis-point decrease in the discount
rate to 5%. In taking this action, the board
approved the requests submitted by the Boards of
Directors of the Federal Reserve Banks of New
York, Richmond, Atlanta, Chicago, St Louis, and
San Francisco.
Market
disappointment On December 11, when the Fed
disappointed the markets with its 25 basis point
cuts of the discount and Fed Funds rates, the
market interpreted Fed language as failing to
offer a clear signal of more cuts to come. The
DJIA decline of 295 points was accompanied by the
S&P 500 closing down 2.5% at 1,477.65, after
being up 0.4% before the decision was released.
Still, the yield on the two-year Treasury note
fell to 2.92%, down from 3.14%, exerting downward
pressure on the dollar. By January 8, 2008, the
DJIA had fallen 843 points to 12,589.07.
The Fed said the deterioration in
financial market conditions had "increased the
uncertainty surrounding the outlook for economic
growth and inflation". But while it dropped its
assessment that the risks to growth and inflation
were "roughly balanced", the Fed did not say that
it now believed the risks to growth outweighed the
risks to inflation. It offered no assessment of
the balance of risks, saying it would act "as
needed" to foster price stability and sustainable
economic growth. This formula in effect meant the
Fed was keeping its options open pending incoming
data which are notoriously inaccurate and
inevitably have to be revised in subsequent
months.
Head
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Central, Hong Kong Thailand Bureau:
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