Reflections on Bernanke’s Yo-Yo Speech

From 11 Big Surprises for the Next Decade

11. New Economic Term Developed, A Yo-Yo Depression- Throughout the first 15 years of the 21st century investors and economists were debating heavily upon the economic environment. Is it deflation, inflation, stagflation or hyperinflation? Eventually, a new term emerged- Yo-Yo depression which describes an economic environment in which the economy moves violently every year or so from inflation to deflation.

Chairman of the Federal Reserve, Ben S. Bernanke, gave a speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming which should be marked as the Yo-Yo speech. Why Yo-Yo? Since Bernanke signaled that in his view there is no point (under current circumstances) in inflating before we get a deflationary shock.
The speech confronts the “inflationists” (those who are calling for hyperinflation) with the reality that the Federal Reserve will not benefit at all from hyperinflation. As I have written in the past, it is a monopoly bank and hyperinflation will wipe out the assets of the banks (And end the Federal Reserve)
On the other hand, as Bernanke’s speech shows, a prolonged period of deflation will also wipe out the banks (and end the Federal Reserve). So the Fed has embraced this Yo-Yo approach where the extreme volatility will push the public into the “safety” of Treasury bonds and leave the market to traders and insiders.

Let’s examine the speech

From Bernanke’s speech:
“I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses. Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations.”

“In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high.”

We wrote about this in Marching towards a Yo-Yo Depression

The Lesson the Markets Thought Bernanke In 2008
In the end of 2007 it was clear that United States was entering a deflationary environment as a result of the housing crash and the credit contraction that had begun. However, since every trader in world read Bernanke’s speech they knew he will act aggressively. As a result, as Bernanke started lowering interest rates in late 2007 the price of oil and agricultural commodities started to rise dramatically. His actions may have delayed the credit crunch to September 2008 but were not enough to prevent the housing collapse. The rise in oil prices only worsened the financial position of U.S households and made the credit contraction even worse. None of his actions helped the ability of debtors to repay their debt. On the other hand he did cause harm by causing consumer price inflation to rise.


Does the Fed Want Hyperinflation?
The Federal Reserve could have started Q.E in October 2007. The plan was already in place, as the helicopter speech clearly shows. But it chose to keep rates at 2%, let Lehman Brothers fail and risk the collapse of the worlds entire financial system. If could have saved Lehman Brothers, like it did A.I.G. It could have printed trillions of dollars and the government could have sent 100,000 dollar check to U.S households, but it didn’t.

As Bernanke said:

“In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high.”

What Bernanke is referring to are credit spreads. The spread between government bonds and corporate bonds was at a record high in March 2009. Once Q.E started, the spread collapsed. The lower yields enabled corporations (and especially banks) to raise large amounts of capital. That had an immediate affect on the economy and on the solvency of the banking system. Besides that, oil was less than 40 dollars per barrel. So the rise from 40 dollars to around 80 didn’t cause a shock to the economy, as the rise from 80 dollars to 145 did in the middle of 2008.

Printing large sums of money (as is needed to prevent a deflationary shock) simply doesn’t make sense from the Fed’s perceptive. Spreads are already low, so money will just run into oil and gold. And that outcome is not what the Fed is wishing for, or as Bernanke put it:

“Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations.”

On the other hand, if/when we get a deflationary shock the fed can print as much as it wants. It will not mind to see oil prices rise in that case, and it will keep the financial system solvent through artificially surpassing bond yields.

Bernanke also responded to the recommendations of Paul Krugman and others who are advocating a massive inflationary policy. At the same day Bernanke gave his speech, Krugman wrote in the New York Times:

“The Fed has a number of options. It can buy more long-term and private debt; it can push down long-term interest rates by announcing its intention to keep short-term rates low; it can raise its medium-term target for inflation, making it less attractive for businesses to simply sit on their cash. Nobody can be sure how well these measures would work, but it’s better to try something that might not work than to make excuses while workers suffer. “

Bernanke confronted this approach directly in his speech:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC.


Such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed’s hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets–including inflation risk premiums–would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.

Despite this approach, he also made it perfectly clear that if the U.S will be confronted with a deflationary crash he will act differently:

“Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.”
Thus, we are in the midst of a Yo-Yo depression, which is the worst possible environment for businesses, since in any other climate they can plan for the future by adapting future debt contracts and business investments according to their expectations of inflation. Under this kind of policy, Bernanke will make sure that they are will always be wrong. If the market expects inflation he will allow a deflationary shock and when it fears deflation he will print money like crazy.

In short, he has turned the entire world economy into a “traders market”.

Read the original story at Israel’s Financial Expert