December 9, 2003
Will the U.S. Fed Enable Future Defeats through their Ephemeral Past Successes?
It all began with an unscheduled 50 basis point rate cut on January 3, 2001…
By Brady Willett & Todd Alway

History teaches us that no matter how well intentioned economic policies and decisions may be, policymakers never can possess enough knowledge of the complexities of the economy nor sufficiently foresee changes in the economic environment to avoid error.
Remarks by Chairman Alan Greenspan   Nov 18, 2002

When the U.S. Federal Reserve Board cut interest rates by 50 basis points on November 6, 2002, the Fed included what was tantamount to a shameless lie in its statement: “With this action, the Committee believes that the risks [between inflation and deflation] are balanced.” At the time, the Fed lied about the risks being balanced (it was clear to everyone that the U.S. economy was in a slump), because it wanted to convey a sense of finality to its easing campaign.

Finality: A final, conclusive, or decisive act or utterance.

Following the 50 point cut, Wall Street concluded that the Fed was nearly out of rate-cut ammo and that any further monetary stimulus measures would be focused on manipulating the money stock and/or by directly purchasing U.S. Treasuries. Keeping the Fed’s historic rate cutting campaign and the November 6, 2002 easing in mind, the events that have taken place since have been nothing short of remarkable.

Lead Up To A Memorable Year

Wasting little time following November 6, the Fed began to toss around overt hints that it had plenty of nontraditional ammo left to defend against economic retrenchment.  To convey the Fed’s intentions Greenspan assured Congress that “we are not close to a deflationary cliff”, and Governor Ben S. Bernanke gave what has become one of the most famous speeches in Fed history. Bernanke’s surprisingly frank comments are worth recalling at this time:

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

Notwithstanding the Fed’s promise to fight deflationary forces with the printing press, in its January statement the Fed offered a ‘balanced’ outlook on prices.  In March the Fed didn’t provide any bias due to uncertainty over Iraq. Suffice it to say, leading into May/April 2003 all in the Fed’s world seemed calm and understandable – so long as the post Iraq recovery arrived on schedule.

Fed Loses Patience

When the expected economic rebound following Iraq failed to immediately materialize, the Fed began to deploy it’s previously talked about plan of action. To be sure, on May 6, 2003 the Fed included the sentence, “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation” in its FOMC statement.  Apparently, or so the Fed wanted us to believe, combating deflation was quickly becoming priority number one.   Remember, “By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar…” -- following the Fed’s comments on May 6 gold fixed at $341.20 (May 7) and has not been this low since.

Locked into the Street’s expectations – expectations that the Fed deliberately helped to craft - Greenspan and company provided yet another rate cut in June 2003. Moreover, the Fed printed as much money as technologically possible in July 2003.  Our deflation fighting heroes unleashed two words in August that are now nearing the point of infamy:

“…the Committee believes that policy accommodation can be maintained for a considerable period” August 12, 2003.

Backing Up The Big Lie

In hindsight, it has become clear (at least to those who appreciate the extremist comments from Bernanke) that the Fed fabricated a threat of deflation to achieve desirable ends – namely the rally in the bond market which did the Fed’s bidding by sending long-term rates lower (remember the May 6 FOMC statement and barrage of speeches and comments from the Fed about the threat of deflation that followed).


Nevertheless, what remains unclear is whether or not the Fed believed it would achieve success as quickly as it did.  Quite frankly, with the U.S. dollar in the dumps, commodity prices soaring, and the U.S. economy growing strongly with some job creation, one cannot help but wonder whether the Fed feels victimized by success. Indeed, when speculating on why the printing presses have paused, one cannot help but wonder whether or not the Fed is readying to declare victory against deflation and blame a weakening dollar and explosive credit expansion as a reason to start raising interest rates.



Incidentally, and again hindsight shines 20-20, it is worth remembering that part of the Fed’s plan leading into 2003 was to weaken the dollar.  This ‘plan’ is the part that is rarely mentioned by Fed members due to potentially deleterious political and trade repercussion: “…the U.S. government can also reduce the value of a dollar” – Bernanke.  Moreover, this part of the plan is why the Fed’s current mandate has become less transparent today.

The Outlook – On Borrowed Time

“Now, confidence is all that holds the economy away from recession, and the Fed is likely to keep cutting interest rates until it hits a nerve – when the systemic response from America will take place is anyone's guess...”
Fed wizardry may not conjure up the desired economic effects. January 13, 2001

With rate cuts probably exhausted, the consensus is that the Fed will raise interest rates sometime next year. A rate increase does not suggest that the systemic response to the Fed’s stimulus campaign is planted upon stable moorings.  On the contrary, this year’s stock market and economic recovery in America has been backed not only by monetary machinations, but also by fiscal stimuli the likes of which have rarely been witnessed in U.S. history. Quite frankly, while it can be argued that the Fed irrationally used a rate cut or two instead of waiting for the next LTCM to happen*, the U.S. government has been borrowing from future generations via record government deficits…this after the longest U.S. expansion on record brought about the shortest, tidiest contraction on record because of increased consumer borrowing.

* Is it rational that the Fed cuts interest rates simply because the economy is soft given that this takes away needed rate-cut ammo if, and when, another financial crisis arrives?

In short, at 2:15:01 today, or when the global financial markets unleash an unpredictable bout of volatility following the Fed’s FOMC statement, remember the events that have unfolded since November 6, 2002; remember that the Fed will lie to the markets to achieve what it believes to be enviable ends; remember that policymakers are not always able to ‘avoid error’.

Why remember the Fed’s triumphant fight against imaginary deflation ghosts when the U.S. economy is growing strongly, job creation has finally arrived, and the stock market rally could be preparing for another leg up?  Because eventually the Fed and the United States government may be faced with a troubling scenario. To be sure, while printing more dollars can weaken the greenback and quell deflationary forces, not even Bernanke can provide a rosy plan of action when it comes to strengthening the dollar and/or stopping its collapse.

BWillett@fallstreet.com     tjalway@connect.carleton.ca