The Consequences of A Loss of Trust

August 3, 2008 Updated: August 4, 2008

Crude oil prices reached record highs a few weeks ago. Now they are down by almost 15 percent. Although this makes some analysts optimistic, we will soon see that it may not necessarily be a good thing.

Commodities traders teach central banks an important lesson

Crude oil prices reached record highs a few weeks ago. Now they are down by almost 15 percent. Although this makes some analysts optimistic, we will soon see that it may not necessarily be a good thing.

Ben Bernanke is the chairman of the Board of Governors of the Federal Reserve. He holds a Ph.D. in economics and has devoted most of his academic career to the study of the Great Depression during the 1920s. He belongs to a group of economists who hold the belief that the Fed was to blame for the depression because it did not prevent the steep declines in the money supply, which turned a "regular" slowdown into a depression.

Bernanke swore it would never happen again, and he backs his words with actions. In 2002, at the peak of the technology crisis, Bernanke was a member of the Board of Governors of the Federal Reserve and one of the major catalysts of an extremely aggressive monetary policy by the Fed in coordination with the central banks of China and Japan.

This earned him the nickname "Helicopter Ben," hinting that he disperses stacks of money out of a helicopter. Following his success he was appointed as the Chairman of the Board of Governors, replacing a retiring Alan Greenspan.

The July 2007 the U.S. credit crunch was a new test for him. It took Bernanke a little bit of time to start acting.

First, he lowered interest rates in September and October. Then, between January and March 2008 he took some of the most aggressive changes ever witnessed: severe interest rate cuts, establishing new borrowing facilities for banks and investment banks to borrow from the Fed, and orchestrating the 11th hour rescue of troubled investment bank Bear Stearns.

These actions, however, prompted some traders in the foreign exchange market to panic and sell the U.S. dollar.

In addition, China and OPEC member countries are obliged to print huge amounts of their own currency in order to keep up with the dollar. This causes commodities investors to react and buy just about anything in order to maintain the real value of their positions.

This drove the global central banks into a difficult dilemma.

On one hand, the credit bubble shows no sign of easing, and on the other hand inflation and commodities prices keep rising. In a subtle way, the central banks chose to deal with the inflation despite the credit crisis and slowing economies.

The Federal Reserve announced that interest rates will stablize and hinted that they may even go up a few ticks.

The European Central Bank raised interest rates, and the Chinese Communist Regime allowed its currency to strengthen sharply and is now even taking measures against the flow of "hot" money coming into China in anticipation of a currency revaluation.

Even central banks of smaller countries, like Mexico, Brazil and India, have raised interest rates despite signs of a slowdown. In other words, commodities and foreign exchange traders have forced the central banks to restrain their monetary policy despite an economic slowdown. To the best of my knowledge, it’s the first time since The Great Depression that central banks are forced to act that way on a global scale.

As of today, interest rates across almost all of the U.S bond market (and in many other places in the world) are near their highest in five years, and the availability of credit is near record lows.

Which mean not only is the monetary policy is not helping the credit crisis, but is instead aggravating it. This unprecedented situation is a result of a loss of faith in the world's central banks and especially in the U.S. Federal Reserve. Bernanke and his supporters are learning the hard way not only the high price of aggressive monetary policy but also the price of the threat of using it.

Itay Slonim is an investment manager in Tel-Aviv, Israel.