Our Case Against the Fed
Jude Wanniski
April 8, 2005


From: "Jude Wanniski" jwanniski@polyconomics.com
To: Ben.S.Bernanke@* * * * *.gov:

From Jude Wanniski, 3:34 pm, 4/8/2005

Thanks Ben... I haven't had a chance to read your comments and questions, but will do so asap.  (I've just been invited to London by the chief of Saddam Hussein's defense team and am trying to wriggle out of it.). 


PS  I hope you did also look at the piece on the Greenspan oil speech. And in it I do address the idea that a de facto gold standard is almost as good as a de jure standard. 


To: "Jude Wanniski" <jwanniski@polyconomics.com>
From Ben S. Bernanke, 3:02 pm, 4/8/2005

Jude:   Thanks for sending this again.

Your arguments for gold I am pretty sure I understand.   The basic idea, which is conventional, is to provide a strong anchor establishing the value of the dollar.   There is certainly historical evidence that maintenance of a true gold standard (as opposed to the gold exchange standard of the interwar period) provides price stability in the very long run (i.e., over decades or longer).  I have three comments/questions about gold:

1)  Under a gold standard, any changes in the price of gold (as a commodity) relative to the prices of the broad basket of goods and services purchased by consumers generate changes in the CPI price level.   Thus shortages of specie led to slow deflation during some periods in the 19th century, while periods of increased gold discovery or improvements in the gold purification process led to periods of inflation.  Inflation or deflation in the short run is also possible if the initial parity when returning to gold is not chosen optimally.  For example, some people think the dollar needs to depreciate more (in real terms) to restore US competitiveness.  If that is in fact true, then fixing to gold today at today's gold price would shift the burden of adjustment onto the price level, i.e., there would have to be a persistent deflation.   In the long run gold production adjusts to stabilize consumer prices but that mechanism does not operate at a horizon of a few years.   Evidently you do not think any of this is a problem.  Why not?

2)  Under a gold standard, higher short-term interest rates is the right response to inflationary pressures.  E.g., a rise in domestic prices reduces competitiveness and leads to gold outflows (the Humean mechanism). To prevent the gold outflows and aid the adjustment process, the central bank (under the rules of the game) is supposed to raise the discount rate, keeping gold at home and reducing the price level.  This is well known.  If a higher discount rate can be used to fight inflation under a gold standard, why not under an inflation targeting (i.e., a consumer-basket) standard?

3)  Gold prices have in fact pretty stable in the past couple of years. Why isn't that a reason to praise the Fed?

Your other argument, that increases in the funds rate increase rather than decrease inflation, still eludes me.  Your empirical analysis, with RBC and MZM, doesn't make sense to me, because it is meaningless to have independent measures of money supply and money demand.   In equilibrium, money supply must always equal money demand; you can't tell them apart. What you are showing in your graphs is that there are fluctuations in the so-called "money multiplier", roughly the ratio of money to the base.  The money multiplier is known to be sensitive to many institutional and seasonal factors.  It's true that higher interest rates reduce the attractiveness of cash and may raise the money multiplier --- this moderates but would not reverse the effects of a higher funds rate on the money supply.  (Also, I would guess that RBC and MZM are positively correlated --- which I would take as evidence that the Fed's actions in the reserve market move the money supply in the intended direction.)

More generally, I don't see how you can say that there is no connection between interest rate policy and the money supply.  Mechanically, hitting a higher funds rate target requires removing bank reserves from the system, as you know (and as I discussed in my speech in Dayton).  So all else equal (more on that qualifier below), a higher rate corresponds to a reduction in the money supply.  Moreover, historically, there is a clear tendency for rises in the funds rate to be followed by a slowdown in both the economy and inflation (this was particularly true before the stabilization of inflation in the late 1980s, which reduced the need for "pre-emptive strikes." )   However, I agree that the use of the funds rate as an instrument raises some issues:

1) One valid question is whether the Fed should focus more directly on interest rates or on money growth as the indicator of tightness.  Long ago, Poole (1970) argued that it depends on which is more volatile, real income or money demand.  In the United States the general view is that money demand is shifted by many institutional factors -- Christmas, tax payments, changes in the mix of deposits, many other things--and consequently is much more volatile in the short run than real income..  If that is the case, the Poole prescription is to focus on the short-term rate, since that requires providing liquidity to automatically offset extraneous (i.e., not related to interest rate, income, or prices) shocks to money demand and maintains money supply-demand balance at the target price level.  An implication of this view is that monetary aggregates can be quite volatile (as they are); however, if that volatility is the result of extraneous fluctuations in money demand which are accommodated by variations in supply at the target interest rate, the effects of the money demand fluctuations on prices are neutralized.  By the way, if there are large fluctuations in money demand, then even under a gold standard, monetary aggregates would be volatile and interest rates would be relatively stable.

2)  There is the question, when using a nominal interest-rate instrument, of distinguishing whether interest rates are high because expected inflation is high or because expected real rates are high.  With inflation expectations fairly stable, and with TIPS and other financial indicators giving us information about inflation expectations, that is less of a problem than it used to be.

3)  The crux of your argument, as I understand it, is that higher interest rates reduce money demand more than they reduce money supply and thus are inflationary.   That would be true if the higher interest rate sharply reduced real income in the short run, enough that the implied reduction in money demand was greater than the reduction in money supply.   It doesn't seem plausible to me that an increase in the overnight interest rate could have real effects on income that are this large in the short run, and I don't know of any studies that would support it.   Indeed, if raising the funds rate is inflationary, as you suggest, the expected real interest rate should not rise much and may even fall when the Fed raises the ff rate.  If the real rate does not rise much when the Fed "tightens", why should real output respond so strongly?  What am I missing?

I am sure you will think I am dense but I am doing my best to understand the argument.



 From: "Jude Wanniski"  <jwanniski@polyconomics.com                                             
 To:  "Ben Bernanke"   <Ben.S.Bernanke@* * * * *.GOV>            
 Subject: OUR CASE AGAINST THE FED            
04/06/2005 10:50 AM                                                       
Jude Wanniski has sent you this PDF report from Polyconomics.com (http://polyconomics.com/).

The fully formatted report may be found at



Mar 28 2005

The responses of the markets to last Wednesday's Fed signal of heightened inflation concerns inspired several questions from clients about our analytical framework and our conclusions that the Fed's rate hikes do not strengthen the dollar. This paper is a staff effort that provides market evidentiary validation of our theoretical framework and analysis...

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