Marching Towards a Yo-Yo Depression

From a June article in the New York Times:

He has predicted that unemployment will remain high for years and that “a lot of people are going to be under financial stress.”


Yet he has been unwilling to use his power to lift growth and reduce joblessness from near a 27-year high. Instead, Fed officials are expected to announce on Wednesday that they have left their policy unchanged, even if they acknowledge that the economy has recently weakened.


How can this be? How can Mr. Bernanke simultaneously think that growth is too slow and that it shouldn’t be sped up? There is an answer — whether or not you find it persuasive.


Above all, top Fed officials are worried that financial markets are fragile. They are not so much worried about inflation, the traditional source of Fed angst, as they are about upsetting the markets’ confidence in Washington. Yes, investors remain happy to lend the United States money at rock-bottom interest rates, despite our budget deficit and all of the emergency Fed programs that will eventually need to be unwound. But no one knows how long that confidence will last.


In effect, Mr. Bernanke and his colleagues have decided to accept an all-but-certain downside — high unemployment, for years to come — rather than risk an even worse situation — a market panic, a spike in long-term interest rates and yet higher unemployment. As the last few years have shown, market sentiment can change unexpectedly and sharply. ..














His worry is a different one.


…In a recent appearance before the House Budget Committee, he spoke repeatedly about market confidence. Specifically, he mentioned “the potential loss of confidence in the markets” if Congress did not come up with a plan for reducing the budget deficit.


There is a direct analogy between the budget deficit and the Fed’s asset holdings. Neither is sustainable. Congress needs to demonstrate that it has a plan for reducing the deficit over the long haul so that investors will be confident enough to continue lending the United States money at low rates.


The Fed, meanwhile, has to show it has a strategy for selling the trillions of dollars of assets it bought during the crisis — without damaging the value of private investors’ holdings and without, at some point, igniting inflation. “The more we buy,” Donald Kohn, the Fed’s vice chairman said last month, “the more assets we will ultimately need to dispose of.” The more the Fed buys, the greater the risk that it will find the point at which the market becomes unnerved.


In the end, Mr. Bernanke’s dilemma has no certain solution. Taking more aggressive action might have only a modest effect on spending, and nobody — including the most passionate advocates for more government action — can really know how long the bond markets will stay calm. The decision comes down to weighing the probabilities and the possible outcomes.


Let’s just be clear about the risks and costs that the Fed has chosen. It is betting that, for once, policy makers are not underreacting to a financial crisis. And it is willing to accept a jobless rate of almost 10 percent, with all of the attendant human costs.

From a July article in the New York Times:

With unemployment high and inflation low, a question is being asked more often and more loudly: Can and should the Federal Reserve do more to get the economy moving?
In two days of Congressional testimony that begin on Wednesday afternoon, Ben S. Bernanke, the Fed chairman, is likely to answer yes, but not just yet.


Mr. Bernanke’s view is that the economic recovery is continuing, though at a modest clip, and that recent developments — the stock market’s swoon, Europe’s financial turmoil and weak job creation — are discouraging but do not yet justify additional monetary stimulus.


Mr. Bernanke says he believes that there are situations that could justify new measures on top of what the Fed has done so far: keeping short-term interest rates to near-record lows and amassing a portfolio of government bonds and mortgage-backed securities, which has put downward pressure on long-term rates.


But to take new action, Mr. Bernanke and other Fed officials would have to be convinced that the economy was moving onto a perilous path of deflation, or that the recovery was so painfully sluggish that it lacked enough momentum to generate private sector job growth…


…There has to be a discussion about whether asset purchases should be resumed if we move into the late summer, and especially into the fall, and we’re seeing a bounce in the unemployment rate and further declines in spending,” he said, while cautioning that he still did not believe such steps were needed.


But all three of those economists agreed that new asset purchases would entail risk.


Professor Klenow noted that buying longer-term Treasury debt might not have much effect on long-term interest rates, because government securities were very liquid.


The Fed might instead consider buying corporate bonds, or assets backed by consumer loans. Doing so could spur the willingness of private investors to lend, Professor Klenow said, but it might not help small businesses, the sector of the economy that needs loans the most. And it would surely spur criticism by economists and others who are fearful about the Fed making decisions to allocate credit by favoring some sectors over others.


In addition, although core inflation, which excludes the highly volatile prices of food and energy, has been running at about half of the Fed’s target of nearly 2 percent, inflation expectations “have not come down nearly as much as one would expect, given how much slack there is in the economy,” Ms. Dynan said.


The size of the Fed’s balance sheet, which has more than doubled since the financial crisis of 2008, and the large amount of bank reserves sitting at the Fed has made officials at the central bank nervous about the potential for rapid inflation once banks decide to start lending more vigorously again, she noted.


“Their caution about deploying more expansionary measures has been warranted, but they need to be watching economic conditions very carefully,” Ms. Dynan said.


A speech Mr. Bernanke gave in 2002, shortly after he left a professorship at Princeton to join the Fed’s board of governors, has been widely cited of late. In it, Mr. Bernanke argued that a determined central bank could always reverse deflation, and generate inflation, through its control of the money supply.


But generating inflation is not the same thing as putting people back to work, a goal that the Fed’s monetary toolbox seems less equipped to meet.


Long-term interest rates are already quite low. The yield on the benchmark 10-year Treasury note has fallen below 3 percent, and the average yield for a 30-year fixed-rate mortgage has hovered around 4.5 percent. With the cost of borrowing so low, the Fed might have reached the point of diminishing returns in its capacity to lower rates further.


Furthermore, if the Fed were to suddenly announce a big new program of asset purchases, it could cause inflation expectations to jump. That could raise nominal interest rates and lead to a rise in the price of oil as investors use commodities to hedge against inflation. In such a worst-case situation, the recession could become even worse.


Mr. Bernanke has been known to recite the first precept of the Hippocratic Oath: do no harm. Those familiar with his thinking compare additional monetary easing to a powerful but experimental drug whose side effects are not fully known.

Then came Bullard with a research paper titled “Seven Faces of Peril”. The paper advocates printing money (Q.E) and not stopping until inflation is comfortably above the inflation target. Bullard even went as far as suggesting that interest rates should rise along with Q.E in order to confront deflationary psychology.

Seven Faces of Peril Final Jul 28 Bullard 2010

And of course on August 10th the the Federal Reserve announced it would reinvest principal payments on its mortgage holdings into long-term U.S. debt securities.

What Can Be Learned from these Contradicting Signals?

The Fed fears deflation, since it will crash the whole banking system. Without inflation debtors will not be able to pay back their loan and the whole financial house of cards will collapse. The government also fears deflation since it will never be able to pay obligations such as the payment of bonds, Social Security, Medicare, Medicaid, etc.

So they want inflation. But necessarily mean they are going to get it. Back in 2002, Bernanke gave his “Helicopter Speech” where he stated:

As I have mentioned, 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.


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.


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).8 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.


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.9 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.


Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

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.

There were three incidences when the Fed was confronted with a run on the Dollar. The first was in 1931, the second in 1979, and the third 2008. In all cases the Fed chose to defend the dollar at the price of health of the economy and the financial system.

The reason is simple. The Fed is a monopoly bank and it doesn’t want to self destruct. Hyperinflation will wipe out the banks since they only hold paper assets and it will eventually cause the destruction of the Federal Reserve itself. If people will not trust the dollars the Fed prints then the Fed will not have any powers at all.

So the Fed decided to print money only when oil and food prices crashed. Then it was free to print as much as it wanted since people were so terrified of deflation. When oil prices went up again, the Fed started to slow down the money printing. It is trying to keep the financial system afloat, along with containing commodity prices as much as it can.

But life isn’t that simple. The Fed can print money, but it can’t control were that money floats. Printing large amounts of money at this stage will only result in a high commodity prices but will do nothing to resume bank lending.

Once there is a big crash, and credit spreads will widen again, the money printing will have some affect since it will help tighten the spreads and prevent large “Too Big to Fail” corporations from going bankrupt. But first the dollar liquidity crunch will play out and cause havoc around the world. When the big collapse of China will come, it will bring down commodity prices to a level where the Fed will feel free to really print money.

Eventually the money printing will result in an inflationary crisis that will end with a deflationary one, creating a Yo-Yo environment.