In case you haven’t noticed, we are in a deflation. Over the past four months, the U.S. CPI is running at negative 7% on an annualized basis.
While it is true that much of that decrease is a direct result of oil plummeting from $140 per barrel to $50, deflation is a huge impediment to recovery. Essentially, in a deflationary environment, consumers do not spend – they wait – because they know the price of goods will be cheaper in the future.
“… suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed’s policy instrument–the federal funds rate–were to fall to zero. What then?”
These are the words of Federal Reserve Governor Ben Bernanke on November 21, 2002.
We are very close to this situation with the effective Federal Funds rate at about 50bp and widespread expectations that the Fed will slash the current 1% rate – perhaps to zero. The Chairman today said that further interest rates cuts are “certainly feasible.”
It is worth reflecting on the options detailed in this speech which explicitly mentions the “helicopter drop” of money.
The Fed has been brazenly expanding its balance sheet.
Do you remember how difficult it was to get Congress to pass the $700 billion TARP program? It failed in the House, was buttressed by some pork, passed, went to the Senate and signed the same day by President Bush.
Last week, the Fed announced that it would drop $600 billion on purchasing mortgage backed securities and other debt from the government sponsored enterprises (Fannie, Freddy, Ginnie and the others).
Where did that dough come from?
Essentially, the printing press.
Why was so little attention paid to it when the TARP created national fervor?
I have no idea.
I am not saying this is a bad idea. However, we need to understand what is going on. First, the Treasury was not prepared to purchase assets – as the original TARP specified. As you know from my previous writing, this left no choice but for the Fed to step in.
They could provide support to asset prices and provide some inflationary pressure to counteract the current deflation.
Let’s consider the November 21, 2002 speech in some detail.
First, Governor Bernanke debunks the idea that you can get trapped in deflation:
“…some observers have concluded that when the central bank’s policy rate falls to zero–its practical minimum–monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.”
Second, he argues that the printing press will solve the problem.
“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
Third, he argues that the Fed must be careful about how it distributes it extra money (I have bolded a certain passage):
“Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”
The bolded passage is what the Fed has started. Whether it is the Commercial Paper program or the recently announced policy on purchasing mortgage backed securities. The next logical steps are to target to commercial mortgage backed securities and corporate debt.
Next, he provides a forecast of our future. He argues that it is not just short-term interest rates that must come down – but long-term rates. He details two methods of reducing long term rates: 1) commit to keeping Fed Funds rate low over a longer period of time and 2) announce explicit ceilings on yields of longer-maturity government debt:
“So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.”
He then argues that this policy would stimulate demand and end the deflation. He portends last week’s action for the “Fed to use its existing authority to operate in the markets for agency debt.”
Bernanke then discusses what might happen if the lowering of long-term government yields does not work. Essentially, long-term government rates might decrease but the cost of capital for corporations could remain very high because of heightened risk premia.
“Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.”
Well, not that restricted. We have seen some of this already. The Fed created a Special Purpose Vehicle to purchase Commercial Paper directly from private issuers in October. I expect we will see more of this.
Bernanke then focuses on exchange rate policy. I do not quote this part because it seems the least likely mechanism.
Finally, what about fiscal policy? Bernanke says it is possible to have a “money-financed tax cut”:
“Each of the policy options I have discussed so far involves the Fed’s acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.”
Hence, the label “Helicopter Ben.” Given the actions we have seen already and given the Chairman’s lucid analysis of policy options, I expect the deflation in the U.S. to be short-lived.
Cam – A few quick thoughts/comments. If China takes the route of managing the downturn through a devaluation of the remnimbi, that could lead to imported deflation to compound the problem. It’s not something I’ve seen in the press yet, but certainly seems a real possibility.
Also, concerning the possibility of setting explicit ceilings for treasuries out the curve, I am concerned about the rising obligations of the US government. The explicit unlimited support for yields through open market purchases of treasuries combined with flat to reduced revenues (between increasing support ratio due to mortality extension and a likely broad based tax cut to stimulate earnings power) would heavily increase the burden we’re resting on the future generations. Not to mention US CDS is already trading 50-60bp to LIBOR.
In your opinion, how likely are we to see Ben resort to hyperinflation in order to stimulate the economy? [I’d secretly love to see a zero or two added to my salary while my student loan and mortgage debt stay fixed.]
I am not sure it is under the radar screen. Alarm bells went off yesterday when the remnimbi depreciated outside the 0.5% band (it was 0.6%). It should be going the other way. You are correct that this is deflationary. It is addressed in the 2002 speech but I did not reproduce that part.
It would be a huge mistake for countries to manage their exchange rates to prop up exports.
It is the classic mistake of the Great Depression.
Countries retaliate. In the end, there is no gain.
Paulson today in a speech told the Chinese that the best way to address their problems was to get their consumers to spend rather than relying on export growth.
Low probability. Velocity of money has plummetted. The growth in supply is counteracting the drop in velocity. Hence, reduces deflation risk.