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.
Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002
I have previously stated my concern with the challenges facing the banking system and the likelihood of its deflationary collapse in the absence of any government intervention. This might actually be the best medicine for the long term health of the economy, but I will have to expand on this point in another post. What matters for investors is that the government will indeed intervene more forcefully, though the scope and effects of its actions are not clear.
I have positioned my portfolio to capitalize on increasing market fear of deflation, but I recognize that the government might be able to eventually print enough money to create inflation and preserve the current financial system; and perhaps print so much money to produce hyper-inflation.
So to get a better sense of how scared the Fed is of deflation and to anticipate its future policies, I thought it would be worthwhile to examine a popular speech made by Bernanke in which he suggests how the US can overcome deflation. This speech was made in 2002 when the US was in recession and consumer prices as measured by the CPI were barely increasing causing many to worry about the onset of deflation.
The following is my outline of Bernanke’s speech:
Deflation: Making Sure “It” Doesn’t Happen Here
- The chance of significant deflation in the US is extremely small.
- US economy is resilient and has the structural ability to withstand such shocks.
- Flexible and efficient markets for labor and capital, an entrepreneurial tradition, ability to cope with technological change.
- Strong financial system.
- Federal Reserve has sufficient powers to preserve price stability.
Deflation: Its Causes and Effects
- Deflation is defined as a general decline in prices.
- Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.
- Deflation is in almost all cases a side effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.
- Deflation of sufficient magnitude would lead to nominal interest rates of zero; and the real interest rate would equal the expected rate of deflation.
- Fed would be unable to utilize its traditional method of stimulating economic activity by lowering short term interest rates
- Maintain an inflation buffer zone of 1-3% during normal times.
- Ensure financial stability in the economy.
- Smoothly functioning capital markets.
- Well capitalized banking system.
- At times of extreme threat, Fed should stand ready to use discount window and other tools.
- When economic fundamentals deteriorate and inflation is already low, Fed should aggressively cut rates.
- Lower medium- and long-term interest rates.
- Commit to holding the overnight rate at zero for a specified time period.
- Enforce ceilings for yields on longer-maturity Treasury debt.
- Purchase agency debt.
- Offer fixed-term loans to banks at low or zero interest while accepting a wide range of private assets (corporate bonds, bank loans, mortgages) as collateral
- Purchase foreign government debt and reduce the value of the dollar in relation to foreign currencies, though this would not be a desirable way to fight domestic deflation.
- A money-financed tax cut would stimulate consumption and investment.
- Increase government spending and acquire real or financial assets; the additional debt issued should be purchased by the Fed with newly created money.
- Why Japan has not ended its deflation?
- Problems in the banking sector have muted the effects of monetary policies and the heavy overhang of government debt has made officials reluctant to pursue aggressive fiscal policies; the US does not share these problems.
- Necessary economic reforms have been avoided by policymakers for fear of the large costs imposed on the economy in the short run.
- Japan’s deflation problem is real and serious; but political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has.
My belief is that money supply growth that until now has been fueled by bank credit is now moderating. Commodities are now sharply correcting because of a stronger dollar and demand destruction. Therefore, consumer prices should follow asset prices and begin falling. This would lead to the “deflation” environment that Bernanke is afraid of.
Bernanke is certainly acting preemptively as the CPI falls within the buffer zone of 1-3% from its current rate of 3.7%. In the meantime, I expect he will continue to provide liquidity to the financial sector recognizing that it’s health is important for creating inflation. The TAF, TSLF, and PDCF programs are going to remain in place for a very long time. These programs help banks with short-term funding problems, but they don’t address the solvency issue the banking system is facing. This is why the TARP was implemented. It pumps capital into banks so that they don’t fail.
I expect the Fed to cut rates until they get closer to zero and signal its intention to keep them low for a long time. But a low Fed funds rate won’t translate into higher bank lending because financial institutions are hoarding capital to restore their balance sheets, consumers are already highly indebted, and businesses will not borrow money and invest in an environment of lower consumer spending. This is very similar to the situation Japan faced in the ’90s.
The Fed has recently recognized the ineffectiveness of further lowering its short-term interest rates. Soon, Bernanke’s suggestion of manipulating medium- and long-term interest rates will be carried out. The Fed will likely purchase longer-maturity Treasury and agency debt with newly printed money in a much more aggressive fashion. Simultaneously, the government will sharply increase its spending in such areas as infrastructure which create jobs. It will also begin purchasing real and financial assets such as real estate, stocks, and bonds. All of this will be financed by selling Treasuries to the Fed which will finance the purchase, again, with newly printed money.
This period of money printing will need to be closely monitored by investors since it will determine whether the rate of inflation will accelerate. But, in my opinion, we are several quarters away from this. Only once the excess capacities of several sectors of the economy are adjusted to meet demand will the Fed’s money printing start to affect prices… but this will take time.