Bernanke’s Deflation Playbook

Today we have a guest post by Daniel Rudewicz, who is the co-founder of Furlong Samex LLC, a deep value investment partnership based on the principles of Benjamin Graham.

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In November 2002, current Fed Chairman Ben Bernanke (then Fed Governor) gave a speech before the National Economists Club, Washington, D.C. titled: Deflation: Making Sure “It” Doesn’t Happen Here

The speech in its entirety can be read here: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

While we do not base our investment decisions on the actions of the Fed, I had previously read this speech on deflation a few months ago and found it an interesting reread. After Tuesday’s announcement the Fed announced it would purchase an additional $750Billion in agency MBS and $300 Billion of long-term Treasuries. When I reread the speech it seemed as if the is speech was a playbook of sorts for Bernanke and his efforts to prevent (or cure) deflation. Bernanke makes the argument that the Fed is not out of tools to fight deflation once the Fed Funds Rate has reached zero. He gives us an insight into what tools he would use to prevent and cure deflation. Below we examine what he has used so far and what may be next. (Below, we have selected small parts of the speech and – if the reader is interested in Bernanke’s thoughts on deflation – recommend reading the full speech posted on the Federal Reserve’s website.) In the “Curing Deflation” section of his speech he highlights the following ways to cure deflation:

“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 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.”

“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.”

“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.”

“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).”

“If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities.” [Emphasis mine]

Author’s note: although the current actions of the Fed could be construed as influencing the yields on privately issued securities, the word directly persuaded me to believe that they have not done this yet. To my knowledge they have not engaged in activities similar to Tuesday’s announcement, where they have purchased privately issued securities to directly affect the yield. Although they have provided backstops in the case of Bear Stearns and also assisted the commercial paper markets, it was not for the purposes of lowering yield. I have left it blank but others may disagree.

“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt. I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar. Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.”

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