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After the first-ever Fed press
conference, gold and silver rose sharply. This was hardly a vote of
confidence in paper money.
Perhaps the
event and the Federal Open Market Committee statement that preceded it were
over-hyped, but both events were disappointing – ducking as they did
the important issue of what happens after QE2 is completed. The statements on
inflation did little more than recognise a
temporary and small – or “transitory” – pick-up in
prices. By revising downwards estimates for economic growth over the next few
years, the Committee claims that inflation will probably subside. In any
event, the Fed is more concerned with the risk of inflation being closer to
zero, given the risk that the economy might then tip into deflation.
All in all,
the statement and the press conference exposed the weakness of the
Fed’s position. We are left with the thought that if a Paul Volcker
were in charge, things would be very different. A return to sound money and a
stabilised dollar would be a pre-emptive strike
against both global and US inflation, and the experience from the Volcker era
is that economic growth was much better than might have been expected
following interest rates of 20%.
But there
is a crucial difference today compared with 30 years ago. The level of
private sector debt is substantially higher, and shows a strong tendency
towards contraction. High interest rates are not actually needed to reduce
demand, because bank credit, which is the counterpart of private sector debt,
has been contracting of its own accord. It is this that frightens the Fed
most, because contracting bank balance sheets are very difficult to manage without
risking a full-blown banking crisis.
So it is
the difficulty of keeping the banking system running while there is credit
deflation in the air that actually pre-occupies the Fed. This is more
important than the official mandate of maintaining a low rate of inflation
consistent with high employment. But by focusing on keeping the banking
system solvent, the Fed is taking enormous risks with monetary inflation. The
unprecedented growth in raw money, reflected in the increase of the monetary
base since the Lehman Bros crisis, has been designed to offset the
contraction of broader credit, and is deemed by the Fed to be
non-inflationary overall.
Economists
generally support this view, taking comfort from the build-up of bank
deposits on the Fed’s balance sheet in the form of non-borrowed
reserves. They argue that only when the banks draw down on these reserves to
use as a base for further bank lending will the inflation risk escalate. But
this argument ignores the fact that this money is already in circulation
through government spending.
There may
have been nothing new from the FOMC statement, and nothing about QE3, but in
the absence of more positive measures the markets have the confirmation they
need that the dollar is headed lower. The Fed is boxed in. No wonder gold and
silver rose so sharply.
Alasdair
McLeod
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