In my previous blog entry, I explained that:
- The current economic crisis could result in either deflation or inflation;
- Deflation and inflation have very different effects on savings and investment vehicles, so understanding the probability of one or the other can help you make better decisions with your money;
- Whether we end up with deflation or inflation depends on whether or not the Federal Reserve can succeed at getting money to move through the economy again.
Our task now is to assess the likelihood of the Federal Reserve achieving its goal.
The Zero-Bound Problem
Ordinarily, the Federal Reserve controls the rate at which money flows through the economy (its “velocity”) by changing the interest rate that it charges member banks for overnight loans (the “Fed funds rate”). Through the mechanics of the commercial banking system, lower short term rates cause a reduction in the rates that banks charge for long term lending, such as car loans and mortgages. Lower long term rates, in turn, stimulate economic activity.
Despite the Fed’s aggressive program of lowering the funds rate in the past year, commercial banks have remained reluctant to lend, and long term interest rates have not declined. Just yesterday, with falling consumer prices raising further fears of deflation, the Fed lowered its funds rate to a record low of 0.25%.
The Fed has arrived at the “zero-bound” problem: it cannot lower interest rates below zero. The Fed has reached the end of the rate reduction paradigm for controlling the velocity of money.
The zero-bound problem explains why, in addition to announcing the rate cut, the Fed announced its readiness to “move to a new phase of monetary policy in which it prints vast amounts of money.” To prevent a deflationary spiral, the Fed must employ other means to get money to move through the system to return the economy to an inflationary track.
In 2002, before he became Chairman Of the Federal Reserve, Ben Bernanke addressed precisely this issue in a speech that earned him the epithet “helicopter Ben.” In his talk, Bernanke reminded his audience of Milton Friedman’s description of a central banker dropping money onto the populace from a helicopter. Also known as the “printing press speech,” Bernanke’s address included the following formulation:
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.
In my last blog entry I explained that inflation is a monetary phenomenon: very simply, an increase in the supply of money relative to the goods and services produced by the economy causes prices to rise. A steady increase in the nominal prices of goods and services discourages savings because, unless interest rates keep pace, unspent money rapidly loses its value. Thus, the plan to “reduce the value of a dollar” serves as a mechanism to fight deflation. Dollar devaluation, we shall see, lies at the core of the Fed’s deflation fighting strategy.
The Fed has done a lot of creative thinking about the uses to which it can put the printing press in order to revive spending. In 2005, Robert Blumen published an article in which he analyzes a number of papers and speeches on this topic by Bernanke and other Fed officials. Few people have the interest or patience to wade through this kind of material. But understanding the Fed’s thinking about deflation fighting gives a good deal of insight into current events, such as yesterday’s announcement. Blumen has done a great public service with his analysis. With his help, I shall now enumerate some of the Fed’s tactics.
- Long-Term Interest Rate Intervention: The Fed can influence long-term interest rates by buying long-term bonds on the open-market. The Fed has already implemented this strategy in order to lower mortgage rates by purchasing mortgage backed securities. Yesterday’s statement makes it clear that the Fed will continue purchasing mortgage securities as well as long-term US Treasury bonds.
- Lending: A 1999 paper, Monetary Policy and Price Stability, explains that “A central bank can also attempt to spur private aggregate demand by extending loans to depositories, other financial intermediaries, or firms and households.” The Fed has already engaged in a record level of lending through its discount window and has been buying commercial paper. Yesterday’s announcement says the Fed now intends to implement a “Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.”
- Currency Devaluation: In a paper entitled Monetary Policy When the Nominal Short-Term Interest Rate is Zero, Fed officials describe the concept of a “money rain” whereby it would “give money away either through directly disbursing currency to the public or by disbursing it through the banking system.” As I observed above, devaluation forces people to spend their dollars to avoid losing their savings. Devaluation, by the way, can also be achieved through what these papers refer to as “exchange rate intervention.” The central banks of other countries might, for example, agree to sell enough of their dollar reserves into the open market so as to effect a deliberate fall in the dollar.
- Imposition of Negative Interest Rate: In the paper Monetary Policy in a Zero-Interest-Rate Economy, a Fed official observes that the Fed could induce people to spend by a mechanism to “make money pay a negative nominal interest rate, by imposing some type of ‘carry tax’ on currency and deposits.” In other words, people saving money in dollars would have to pay for the privilege of doing so.
- Direct Purchase of Goods and Services: By exchanging federal government debt for freshly printed money, the Fed could indirectly “conduct an open market purchase of real goods and services.” This idea, also presented in Monetary Policy in a Zero-Interest-Rate Economy, may sound far-fetched. But it might be what yesterday’s Fed statement hints at by saying it will “continue to consider ways of using its balance sheet to further support credit markets and economic activity.”
This inventory of ideas gives a pretty good idea of just how far the Fed will go to reflate the economy. As a student of the Great Depresion, Ben Bernanke believes it necesary to fight deflation with these types of tools to avoid long-term economic suffering. As one can see from the developments of the past several months and from yesterday’s Fed statement, we must take these ideas at face value. We must understand them not as theoretical possibilities, but as an armamentarium of tactics that it fully intends to deploy now that it has reached the zero-bound. Very simply, the Fed will stop at nothing to prevent deflation.
With this understanding of the Fed’s strategies as background, I am confident that the deflationary trend of the past months will not last long. It could continue for a number of months into 2009, or perhaps even into 2010. But I have little doubt that, by dint of its creative application of monetary authority, the Federal Reserve will prevail.
What Will Happen To All That Money?
Mainstream economists view inflation of around 3% or so as benign. A bank CD paying interest of 5%, or a long-term bond paying 8%, would compensate for inflation and leave the investor with a reasonable return. The mainstream investment and economic community assumes that, one way or another, the Fed will target a reasonable level of inflation once the crisis has subsided.
And, indeed, the Fed has mechanisms for “mopping up” the excess money it creates in order to prevent excessive inflation. The Treasury can deposit the proceeds of bond sales with the Fed, taking those dollars out of circulation and reducing their inflationary effect. The Fed can also increase the reserve requirements for banks. For example, by increasing the deposit to loan ratio from 10% to 15%, less money would circulate through the economy. And of course the Fed can raise interest rates.
But one has to wonder whether the Fed, or the government, would have the discipline to throw cold water on an economy recovering from a severe recession. A monetarily responsible Fed under Alan Greenspan should have raised interest rates when the economy showed signs of recovery from the dot.com bust. Its failure to do so led to the housing bubble that caused the current recession. Our economy’s addiction to credit as a vehicle of economic “growth” will make the Fed reluctant to slow down credit expansion as the economy recovers.
More importantly, in the coming decades our government will be forced to adopt a deliberate policy of inflation to cope with the national debt. Our national debt has reached over $10 trillion. Adding future entitlements such as Social Security and Medicare to the mix brings the total in coming years to a mind-boggling $70 trillion. And, of course, all of the bad corporate debt that the Fed continues to buy in order to rescue the banks adds to this burden.
Inflation can serve as a release valve for any government facing this level of debt obligation. You’ll recall from my discussion of the mortgage as a hedge against inflation that inflation transfers wealth from creditors to debtors because the nominal value of the loan decreases as the nominal value of the underlying asset inflates. In a similar way, the government’s obligation to entitlement beneficiaries (most notably retirees) becomes a smaller burden when inflation persistently and steadily devalues the nominal value of the fixed payment. It has the same effect on the government’s debt to international creditors, such as China, who hold large dollar reserves in treasury debt.
Bear in mind, too, that since the government controls inflation statistics, it can control whether and to what extent entitlement payments keep pace with true inflation. Please review John Williams’ work on inflation for more about the true rate of inflation.
Ultimately, an economy that depends on an indefinite expansion of credit to sustain its growth cannot go on forever. Eventually, debts must be paid. In the current crisis the Fed is introducing the world to the printing-press approach that will later serve to cope with the country’s debt.
But eventually this strategy must fail. Relentless devaluation of currency renders it worthless. The dollar must die eventually.
How To Save And Invest
I do not believe that a currency collapse is imminent. The more likely scenario is a slow burn lasting for decades in which a series of booms and busts will obfuscate the underlying trend towards hyperinflation.
In the short term (for the next year or so), the prices of stocks and consumer goods may continue to fall due to the the effects of defaulting credit and gloomy economic reports. In any economic climate, a prudent savings and investment strategy would keep enough emergency funds in cash (short-term bonds and bank CDs) in case of protracted unemployment or other exigencies. Just bear in mind that the cash you would need in the short term for emergencies will lose its value over the long term as the Federal Reserve pursues its policy of relentless and deliberate devaluation of the dollar.
A long-term portfolio should include some percentage of investments that hold their value independently of the monetary system, such as commodities, precious metals, and businesses that produce food and energy.
DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.
© 2008 Philip Glaser