Two Reasons Why Central Bankers Had No Choice but to Reduce Interest Rates

Oil held at $99 yesterday. The Dow dropped 9 points. And the dollar fell to its lowest level ever against the euro. If you want to buy a euro today, it will cost you $1.51 cents.

Gold shot up too – another $12, bringing the price to a new record of $961.

Why is the dollar falling? Why is gold going up?

You already know the answer, dear reader. Because the people who look after the dollar want it to go down. They’re doing all they can to make sure it loses its value. And so far, at least at that, they’re succeeding.

“Dollar hits low as Fed chief hints at rate cut,” says the Financial Times. “Bernanke says bank will act to support growth.”

The Fed is caught in the same crossfire as everyone else. On one side, housing prices are dropping… consumers are running out of money… and banks are afraid to lend. On the other, the supply of paper money is soaring… forcing up prices for just about everything that isn’t a financial asset.

Oil… gold… copper… wheat… tractors… farmland – they’re all being pushed up by inflation.

Central bankers don’t normally reduce interest rates in the face of rising consumer prices. But our poor Bernanke-led bank consortium feels it has no choice. The cannons of deflation to the left of them… the artillery of inflation making louder noises to the right – they’ll attack on the left!


Two reasons. First, they believe they can lick inflation any time. That was what Paul Volcker showed them 25 years ago. Inflation can be beaten by clamping down on lending… raising interest rates… and tightening up on the money supply.

But deflation? The present generation of the world’s central bankers watched Japan struggle for 18 years. They think they learned something.

The Bank of Japan has economists too. They read the same economics textbooks. They attended the same prestigious universities. They believed the same claptrap theories of dead economists. They cut rates down to “effectively zero” (monetary policy)… and they spent more on useless government projects than any government had (fiscal policy). What more could they do?

(Well, Anglo-Saxon critics said they were wimps, unwilling to let the big banks fail, so the economy could get back on its feet. More on that later.)

Central bankers are more afraid of deflation than they are of inflation, in other words, because they find it a harder disease to cure.

The second reason why the Fed is attacking deflation and not inflation is purely political. “Change” may be something every candidate promises, but it is something no candidate really wants… at least, not the sort of change that Mr. Market is sending their way. After a huge boom… Mr. Market is delivering a correction. That is just the way he does business. Boom… bust… and boom again. But neither the voters nor the politicians are very keen on the bust part. And they all think they can… and should… do something to prevent it. Hence, the Fed fights deflation… and leaves inflation alone, since they believe that inflation instigates growth (and is often mistaken for growth by casual observers).

But it looks to us as though BOTH deflation and inflation are becoming more dangerous.

“Inflation may be worse than we think,” says a Wall Street Journal article. Yes, we wouldn’t be surprised.

One thing that is definitely going up fast is the price of gasoline. Per gallon, drivers are paying 19 cents more than they did just two weeks ago. Some experts think the price will go to $4 per gallon before the summer comes. This is very bad news for the consumer.

“You’re adding an oil shock on top of a crunch on credit and a housing collapse,” said Nigel Gault, an economist at Global Insight. “Even the U.S. economy cannot withstand all of that at the same time.”

As anticipated, consumers are doing the only thing they can do, they’re spending less money:

“Retail earnings dive,” reports the New York Times. What happens to a consumer society when consumers stop consuming? Ah, dear reader, you know the answer to that too – it shrinks.

Our first extra thought is that we should move more money out of the dollar. It just keeps going down against the euro and gold.

Our second thought is that we don’t have a second thought. So we’ll go back to the first thought.

The problem with this thought is that it is too obvious. The world’s governments are flooding the planet with paper money. Gold is a kind of Noah’s ark. It can preserve our capital until the excess liquidity dries up. No wonder everyone wants to get on board.

In the United States, as we keep pointing out, the supply of paper money is rising three times the speed of GDP growth. In places like Russia… it is growing five or six times as fast as GDP. China’s inflation is at an 11-year high… and at more than 7% is becoming alarming. Don’t expect Chinese exports to hold down prices in the United States anymore… now they’re just another inflationary pressure.

Meanwhile, the masses are deeply in debt. Their major asset is what they live in, and house prices are about the only thing going down. Their only other major resource is their own labor – which is overpriced in global terms. Inflation will bring it down to more competitive levels.

The government is deeply in debt too. It has let out notes it can’t pay… sold bonds it can’t honor… and made promises it can’t keep. Inflation, there too, would reduce the burden.

What’s more, the custodians of America’s paper money – as we point out above – are desperate to avoid price stability. They want the dollar to lose value; they see it as the only way they can prevent Mr. Market from doing what comes naturally.

And we will add one extenuating circumstance just to thicken the plot: the great dollar-based empire is probably peaking out. Since WWI, America has been the world’s hegemonic power. Since WWII, the dollar has been the world’s hegemonic currency. And since 1971, the hegemonic money has been on its own… unsupported by anything harder than cellulose. But nothing lasts forever. China, India and Russia have come into the global market. They’re shaking things up… growing fast… and offering U.S. business more lower-cost competition than they’ve ever had to face before. Wealth and power is being blown across the Pacific with the trade winds… from North America to Eurasia.

All of this signals, to us anyway, a cheaper dollar and a lower standard of living – relatively – in America. In terms of gold, we expect the dollar to be worth less. Then again, since all currencies are now in competition with the dollar… we expect gold to go up against them all.

And since the U.S. authorities will likely struggle so hard to prevent this unpleasant change, it also seems likely that the price of gold will at least recover to its inflation-adjusted peak set in 1980. Then, gold briefly hit $850. But that was when the dollar was worth a lot more than it is today. Adjusting to current dollars, we expect to see the price hit $2,500 before this bull market in the yellow metal is over.

The only thing that bothers us about this forecast is that it is so obvious.

Bill Bonner
Markets and Money

Bill Bonner

Bill Bonner

Since founding Agora Inc. in 1979, Bill Bonner has found success and garnered camaraderie in numerous communities and industries. A man of many talents, his entrepreneurial savvy, unique writings, philanthropic undertakings, and preservationist activities have all been recognized and awarded by some of America’s most respected authorities. Along with Addison Wiggin, his friend and colleague, Bill has written two New York Times best-selling books, Financial Reckoning Day and Empire of Debt. Both works have been critically acclaimed internationally. With political journalist Lila Rajiva, he wrote his third New York Times best-selling book, Mobs, Messiahs and Markets, which offers concrete advice on how to avoid the public spectacle of modern finance. Since 1999, Bill has been a daily contributor and the driving force behind Markets and Money.
Bill Bonner

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1 Comment on "Two Reasons Why Central Bankers Had No Choice but to Reduce Interest Rates"

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Major Tom

“And since 1971, the hegemonic money has been on its own… unsupported by anything harder than cellulose.”

That statement is wrong. Since Nixon closed the Gold Window in 1971, the dollar has since been backed by oil, although it’s not something the US government chooses to emphasize. And that means that even if the dollar falls, it won’t fall to zero.

But Bonner is right, the dollar is on the way down.

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