IT’S WORTH COMPARING THE ABSENCE of fuss surrounding the transition at the Federal Reserve Board, now with a new chairman, to the intense scrutiny given to the new Supreme Court appointee. The two jobs are entirely different, of course, but one reason for the disparity of interest is that the Supreme Court has gained enormously in power, while the Federal Reserve Board has lost power, to an almost equal degree.
The accumulation of power by the Supreme Court has been much discussed, so I will say no more about that. The loss of much of the Fed’s discretionary power over the last 20 years has received far less attention. In fact, it is only vaguely understood. The Fed still has the power to create money out of thin air, meaning that it has the ability to reduce the purchasing power of savings. Theoretically, therefore, it can still do much harm, as it did at the time of the Depression. In practice, however, that dismal performance will be hard to repeat.
In the 1920s and ’30s, the Federal Reserve Board consisted of bankers who didn’t quite know what they were doing. They were like technicians at the control panel of a power station, but who didn’t know which dials to watch. Hardly anyone in the country knew what was going wrong at the time. The Federal Reserve held the money supply way too tight, and in so doing catastrophically steered the economy off a cliff. It would be difficult for that to happen today because red lights on the display panel of the economy would be blinking, market signals would be screeching, and policymakers would be unable to ignore the racket.
The Fed’s job is to keep the dollar on an even keel; neither diminishing nor increasing its value by expanding or contracting the money supply too rapidly. Encouraged by Congress, Fed chairmen often aspire to a more ambitious role; playing with the unemployment dial, for example, or urging the economy to grow at a certain rate, or delivering sermons against budget deficits. But all these goals are inappropriate to the Fed’s function. If it keeps the dollar steady, it will do right by the economy in other ways.
In contrast to earlier times, the government has little incentive to devalue the currency today. By devaluing its coin, a government can silently repudiate its debts. It can incur war debts, for example, and pay them off in nominally unchanged but actually depreciated currency. But markets are much more sophisticated now, making it harder for debtors to deceive creditors. The interest that governments have to pay on long-term bonds would immediately rise to reflect an inflation premium. And since 1997, the Treasury has issued inflation-protected securities, which discourage recourse to inflation. These bonds pay a fixed rate of interest, but the principal amount is adjusted upward every six months to reflect changes in the Consumer Price Index.
In the 1970s, when inflation spiked twice and reached 13% in one year, long-term interest rates rose to 15% and the gold price exceeded $850 an ounce. Gold, which once played an essential role in the monetary system — dollars could be exchanged for gold at a fixed rate — and was then (by law) banished, in effect forced its way back into the monetary system, although without official recognition. Wary savers exchanged undependable paper for metal that could not be counterfeited.
Since the late 1970s, a number of influential analysts have viewed the gold price as an important indicator of the dollar’s value. Gold cannot be printed by the government, and the theory underlying the gold standard is that new gold is discovered at a rate that is roughly proportional to the overall level of economic activity. If the gold price rises noticeably, therefore, it is (perhaps) a sign of inflation.
I said that a destabilized market emits distress signals. And here we come to a dilemma — a conflict in the messages that markets are transmitting right now.
GOLD HAS RECENTLY INCREASED quite sharply in value. Its spot price in January was about $550 an ounce; up from $425 a year earlier. Steve Forbes takes this as a measure of inflation (which rose by 3.4% in 2005), blames the outgoing Fed chairman Alan Greenspan for tolerating it, and adds that he “will have left town before his inflationary blunders become all too evident.” The Fed has been “printing an excessive amount of money,” Forbes believes, and urges the incoming Fed chairman, Ben Bernanke, to “mop up the excess liquidity until the price of gold comes down to a tad below $400 an ounce.”
Well, who am I to argue with Steve Forbes, who publishes an excellent magazine and has been studying gold signals for years. Gold has indeed proved to be a reliable early warning indicator. Forbes is therefore concerned that Bernanke “disdains gold” both as an indicator and as a guide to monetary policy.
But my concern is that another reliable harbinger of inflation has been sending a very different signal. The remarkable fact is that the inflation premium on long-term bonds has all but disappeared. In fact, as I write, the “yield curve” is inverted. You actually pay a lower interest rate to borrow long than to borrow short (4.377 percent on a 10-year note as opposed to 4.378% on a 2-year note).
This appears to be a worldwide phenomenon. A Wall Street Journal reporter noted that the yield on Britain’s 50-year gilt “fell to a record low of 3.48 percent this week, prompting the pension industry to call on the government to issue more long-term debt.” The yield curve is also inverted in Australia — lenders accept lower interest rates when they lend long-term. This is amazing, and in my view needs explaining. Markets, said Dow Jones Newswires, “have been thick with theories about what is keeping a lid on yields.” One possibility is a “global savings glut.” Another, China’s “ability to flood the world with cheap goods and soak up inflation.”
An inverted yield curve is often taken to herald a downturn. Another possibility, in opposition to Forbes’s view, is that monetary policy is almost everywhere too tight. If so, the rising gold price cannot be taken as a harbinger of inflation and requires some other explanation. One possibility is that private wealth is rising in India and China more rapidly than mining operations can add to the supply of new gold. Tens of millions of people in those populous countries could well be demanding gold as a personal hedge against the expropriationist inclinations of their own governments. Possibly, then, the gold price is misleading and the long-bond message is more reliable.
THE RETIREMENT ACCOUNTS of tens of millions of Americans are directly at stake and the Fed is no longer in a position where it can indulge the political whims of the President or anyone else. The Fed has no choice but to preserve the value of the dollar, with minimal fluctuation. (Another unknown in these uneasy financial equations is the future of tax rates. In 2003, President Bush reduced tax rates on capital to excellent effect, but the old rates are due to return in 2008; if not made permanent, stock market prices could drop by 10% or more.)
Myself, I do not know whether bonds or gold are the more trustworthy indicators. They are not normally in conflict and both have been reliable in the past. For the private citizen, the important thing is to retain humility. As someone said of personal judgments about the market — “don’t fight the tape.” Submit to the numbers — they know more than you do.
As to the Fed, these powerful and ceaseless market signals cannot be ignored by any Fed chairman, whatever his private inclinations. The institution he controls is hemmed in and guided by markers and beacons so insistent and strong that policy errors cannot be sustained for long. Errors that endured for years in the 1930s now have a lifespan of weeks. In the end, Ben Bernanke will have to do more or less what markets instruct. The Supreme Court operates with no such constraints.
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