Ben Bernanke was at Jacksonville University this past Friday discussing the Federal Reserve with college students.  It’s actually a very good discussion.  He goes through the banking crisis step by step and provides a very clear explanation of the Fed’s role during the crisis.  He confirms most of what I have been repeating for weeks now.

Most importantly, however, he explains what the Fed is doing going forward.  He makes several critical points:

  • He explains that the Fed “is not printing money”.  They are merely swapping treasuries for deposits (sound familiar?).  As he mentioned in his op-ed the other day there is no reason to believe this operation is inflationary.  It alters the duration of debt outstanding and nothing more.  QE IS NOT INFLATIONARY.
  • He says the price increases in commodities (caused entirely by speculators and not fundamental changes) are not a concern because the slack in the economy will make it difficult to pass these costs along to consumers (sound familiar?).   Unfortunately, I think the Chairman is overlooking the fact that corporations will be less likely to hire as they see their margins squeezed.  This is a significant issue the Chairman appears to be glaring over.  It should not surprise any of us that he is viewing this environment as an academic and not as a business owner.  Just one more piece of evidence showing he is unqualified for this position.
  • The Chairman proves that he absolutely does not understand how the US monetary system functions when he says that the US is analogous to Japan in that we have high government debts.  He claims that Japan funds their debt internally clearly implying a solvency constraint.  He goes on to explain that the US budget deficit creates risks for the country despite previously explaining that high inflation is not a problem. Clearly, the Chairman believes the government balance sheet is no different than a household balance sheet.  No wonder he has had this crisis wrong since before it started.

Updated: For those who don’t have the time to listen to the interview here is the important directly from the Fed Chief himself (courtesy of reader LVG):

“What the purchases do… is… if you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system. Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed. Now the question is what happens the economy starts to grow quickly and it’s time to pull back the monetary policy accommodation. There are several tools that we have”

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Think of it this way, that Debt the bank holds has a 5 year expiration, at which point it will be redeemed for cash. The fed is shortening that duration and expiring that debt for cash today instead of 5 years from now. That’s not creating anything new in the system (the debt to money conversion) it’s just shortening the time horizion of it.

    The Fed’s holdings (ie Reserves and US Debt) are not factored into money supply and debt. All profit the Fed makes is retired and credited back to the government (with the exception of funds for operations and research). The Fed has the ability to create and retire money. So when the fed “creates money” to buy debt, it’s exchanging dollars (Reserve Notes) today for dollars (Reserve Notes) in the future. They buy these from the banks, not the Treasury, so when redeemed the banks would be receiving Fed dollars no matter what.

    Their operations are currently interest targeting, not reserve targeting. As TPC has pointed out numerous times, they do not lack reserve supply and adding more reserves isn’t going to create any more inflation than is already present aside from financial assets inflating . However, it does have unintended consequences (front running the fed actions, capital flight to foreign assets, dollar depreciation due to low targeted return rates, “currency wars”, and most of all faith in the currency).

    All fiat currencies need faith in their values and whether actions are inflationary or not (and more accurately when rates are held low too long, artifically) the belief becomes self-fulfilling (a negative feedback loop). Fear of a dollar debasement leads to people fleeing it as a reserve leading to it falling more, but inflation based on debasement and purchasing power takes time (a lag) to get into the system. The higher equity prices today are not reflective of core inflation increases, it’s based on interest rates and expecting them to be lower (or stay low) for an extended period keeping the relative return of risk-free treasuries lower when compared to stocks driving up the price of relative assets, ie stocks and commodities. The debasing we see today is more in relation to foreign market inflation (foreign markets are raising rates to tamp down inflation making return in their currencies more appealing, leading to a net outflow of dollars)

    As for inflation, money supply and inflation are not perfectly correlated. You need demand and productive capicity for them to link. As Friedman described you can print 1 trillion dollars and bury it in your back yard, and it will not inflate a single thing but the ground. The slack in capicity utilization in our economy is not sufficient enough to see inflation simply from “printing money” (maybe it would if we were at fully utilization) or in this case “asset swapping”.

    Next up…dropping money from a helicopter and hoping for a “Wealth Effect” to set in!

  2. Yes, and there is no inflation if you strip out the ‘volatile’ food an energy components also.

    The denial of inflation is a common occurrence among governments, believe this and the ‘asset swap’ story at your peril.