In God We Trust: Not Ben

Ben Bernanke really worries me when he says things like this:

When Rep. Jeb Hensarling (R-Texas) asked yesterday about the spike in prices for gold, oil, wheat, and other commodities , Fed chief Ben Bernanke—whose expansion of the money supply over the past three years amounts to a highly confident gamble on the Fed’s ability to control the devaluation of the dollar—dismissed the idea that this inflation was related to Fed policy, noting that “commodity prices have risen just about as much in other currencies as they have in terms of the dollars. So while I take those commodity price increases very seriously I don’t think they’re primarily a dollar phenomenon.”

This is disturbing for at least two reasons  First, it stretches the limits of the meaning of the phrase “just about as much.”  Since September, 2010, as measured by US dollar index futures, the US dollar has fallen by about 7.5 percent.  There was a rally into the first part of 2011, but then the decline resumed: it has fallen nearly 5 percent from the end of 2010.  This means that commodity prices in non-dollar currencies have risen by about 7.5 percent less than dollar prices in the period that commodity prices have risen substantially.  That doesn’t seem “just about as much” to me.  If 7.5 percent is close enough for government work as far as Bernanke goes, that’s grounds for serious concern.

Second, it is disingenuous in a way similar to other, earlier Bernanke statements.  It is not honest to say that one cannot attribute rises in commodity prices denominated in other currencies to an expansion in the stock of dollars.  Foreign central banks don’t want to see a dramatic strengthening of their currencies relative to the dollar.  They therefore respond to US monetary expansion by expanding their own money supplies.  In a fixed exchange rate world, inflation rates will be equal in all currencies, and a US monetary expansion would lead to world inflation as to maintain the fixed rate foreigners have to expand their money supplies to match the US expansion.  Exchange rates aren’t fixed today, but they are not passively floating either.  To the extent that foreign central banks attempt to fight appreciation of their currencies, they import some American inflation.  Thus, the fact that commodity prices are rising in other currencies does not mean that commodity inflation is not a dollar phenomenon, and it is disingenuous of Bernanke to claim otherwise.  The initiating shock is the US monetary expansion: the channel of transmission is the monetary policies of other countries attempting to avoid a sharp appreciation of their currencies.

To the extent that Bernanke and the rest of the Fed governors truly believe that sharply rising commodity prices are not a harbinger of inflation, and hence ignore danger signals from the commodities markets, there is a real danger that inflation in other prices can spurt quickly, before the Fed can act.

The monetary base has expanded dramatically.  It is common to downplay the importance of this phenomenon by pointing to the fact that most of the reserves that constitute the vast bulk of the expanded base are held as deposits at the Fed, and that as a result, velocity has plunged.  That raises two questions: (a) if the expanded money base is just sitting around, how is it doing anything to generate a rise in real output?, and (b) what happens if velocity ticks up, even modestly?  Question (a) casts doubt upon the benefits of a dramatic expansion in the monetary base.  Question (b) raises serious concerns about its dangers.

Here’s an analogy.  There’s a huge amount of dry kindling lying around.  It’s not doing anything damaging at present, but it’s not doing any good either.  It represents a fire hazard, but it’s not burning now, so the fire marshal calmly states that nobody should worry, and he can readily douse any flames, so there’s no reason to clear the kindling.

Somehow, that’s not very comforting.  What’s the upside for having huge amounts of fuel lying around, doing nothing?  The downside is clear: it could explode into a major conflagration.  The calming words of the fire marshal don’t inspire true confidence, especially when he tells everybody to ignore smoke rising from a part of the woodpile.

The reserves are the kindling; Bernanke is the fire marshal; and the rising smoke is the rise in commodity prices.  The risk of an inflationary conflagration breaking out–a big one–seems very real to me.

The US currency says “In God We Trust.”  The problem is, when it comes to avoiding a substantial inflationary spurt, we have to trust in Ben.  But Ben ain’t God, and that’s cause for worry–especially when he gives such dubious justifications for his policies and its effects.

About Craig Pirrong 223 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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