Sunday, October 26, 2008

Bernanke, the Fed and Inflation

the Fed did not actually open the monetary spigots until a little over a month ago. Up until then, Bernanke effectively sterilized all his monetary injections, either by directly trading Treasuries from the Fed's portfolio for riskier financial securities, or by indirectly loaning to financial institutions with money recouped by selling Fed-held Treasuries on the open market. Either way, there was no major impact on the monetary base...

one of the problems with the Fed's early response may have been Bernanke's fear of potential inflation, as the RELATIVE prices of oil and other commodities headed upward. He therefore tried to do the impossible: simultaneously avoid inflation by holding the line on monetary growth, while warding off a potential deflationary bank panic by injecting liquidity into selected institutions. The market's confusion over these cross purposes seems to have actually prolonged and deepened financial difficulties. In fact, a desire to achieve both goals simultaneously was a primary motive behind the dreadful Treasury Bailout...

It also means that the total bailout is not the $700 billion that Congress appropriated but at least $1.2 trillion. Nor does this count the Fed's recently promised $540 billion bailout of money market funds, which if not covered by the Fed's sale of other assets, will require either further monetary increases or further Treasury borrowing. Thus we now have the worst of both worlds: a massive bailout financed BOTH by Treasury borrowing, in order to avoid inflationary pressures, and a monetary base increase, heralding future inflation anyway...

Future historians may someday refer to this sad episode as the Bernanke-Paulson Recession, concluding that it was the policies of those two individuals, more than any other factors, that turned what was not even a mild recession into a major economic downturn.

read the entire essay

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