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Tuesday, November 26, 2002

Ben Bernanke Muses on Deflation: Just Hypothetical Of Course

In his recent speech 'Making Sure "It" Doesn't Happen Here', Ben Bernanke, governor of the Federal Reserve Bank and distinguished academic and economic historian of the thirtees depression asks the question: it won't happen, but what if it did? Bernanke points to the considerable powers of the Fed has in shaping monetary policy, and in creating money and inflationary expectations. In particular, and perhaps most controversially, he reflects on the possibility of direct intervention to reduce the value of the American currency. This all assumes that other economies are in a position to bear the load. It is here I think, that I perceive the greatest weakness in the landscape described by Bernanke. For it is difficult to imagine that the main burden of a weaker dollar policy will be borne by Japan, and it is way-to-soon to imagine the responsibility can be shouldered by China. So this leaves us with Europe (assuming that Germany hasn't already entered the deflation trail, and that the ECB isn't already trying to out-Bernanke Bernanke). The consequence initially of a dollar drop would be to shoot the Euro into the air, from which elevated height it could only do one thing: fall. Perhaps the greatest weakness in the Fed's anti-deflation drill at this stage is the assumption that Japan and Europe aren't growing because their central banks aren't doing enough. What if this whole perspective is wrong. What if this growth potential just isn't there, and what if the problem is altogether more serious? Perhaps we should dig a little deeper before congratulating ourselves that we have it cracked.

So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself.....The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

The sources of deflation are not a mystery. 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. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.

Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be.To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible.

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy.

First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero.6 Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times.

Second, the Fed should take most seriously--as of course it does--its responsibility to ensure financial stability in the economy. Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks.

Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates (Orphanides and Wieland, 2000; Reifschneider and Williams, 2000; Ahearne et al., 2002). By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.

As I have indicated, I believe that the combination of strong economic fundamentals and policymakers that are attentive to downside as well as upside risks to inflation make significant deflation in the United States in the foreseeable future quite unlikely............

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 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). 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.

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. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. 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.
Source: Federal Reserve

Meanwhile Stephen Roach informs us that this speech together with the recent 50 bp monetary easing means that the Fed finally gets it. The "it" in this case is deflation. Bernanke's speech, he says leaves little doubt in his mind that the Fed has gone into a full-blown anti-deflation drill.

It would be rare, indeed, for the monetary authority to warn explicitly of the imminent perils of deflation. And so, as key Fed officials have now gone on the offensive against deflation in recent days -- namely Chairman Alan Greenspan and Governor Ben Bernanke -- they have done so under the guise of the "low probability what-if." The likelihood of deflation is still characterized as "remote" or as "extremely small." But once those predictable caveats are dispensed with, it’s on with the battle.

The Fed’s focus in countering deflation is mainly on a broad array of so-called nontraditional instruments. This is of obvious importance given the limits that are now looming for its traditional instrument -- the federal funds rate. The Fed, of course, has taken the overnight lending rate down an astonishing 525 bp since early 2001, with only 125 bp to go before it hits the dreaded zero nominal interest rate boundary. Yet both Chairman Greenspan and Governor Bernanke have gone out of their way to stress that the Fed is far from out of ammunition once the funds rate hits zero. After all, the central bank has virtually unlimited capacity to purchase Treasuries or the so-called agency debt of organizations such as Ginnie Mae. Or the Fed could subsidize bank lending, directly spurring the private credit cycle. Or the Fed could monetize any number of fiscal schemes to stimulate the economy. Governor Bernanke makes the point that since under a paper-money system there is really no limit to such extraordinary efforts at liquidity creation, "a determined government can always generate higher spending and hence positive inflation." What he doesn’t state, however, is how difficult it may be to achieve such an outcome for a saving-short, overly indebted US economy. Yes, money must go somewhere, but initially it might be channeled into balance sheet repair, paying down debt, or a restoration of saving before it ends up in the real economy or the price structure. There are no guarantees of instant policy traction near a zero rate of inflation.

In his discussion of nontraditional options to counter deflation, Governor Bernanke also makes note of the potential role of a dollar devaluation. I believe this is the first such public mention of such a measure by a senior US government official. It is also an option that I have long favored as an anti-deflationary measure (see my 26 September 2002 Special Economic Study, All Eyes on the Dollar). Most importantly, a weaker dollar would have the effect of transforming imported deflation into imported inflation. Given the ever-present risk that traditional counter-cyclical initiatives of the monetary and fiscal authorities may be too late to stave off deflation, currency devaluation may well be a perfectly legitimate last-gasp effort. But there is an added benefit: A devaluation of the dollar would likely also force foreign authorities -- especially those in Europe and Japan -- to adopt long-overdue pro-growth policy strategies of their own. An extremely lopsided global economy -- actually more US-centric than ever before -- needs a shift in relative prices in order to correct the extraordinary disparities that have opened up between the current-account deficit nations (mainly the United States) and the surplus countries (especially Europe and Japan). As the world’s most important relative price, a realignment in the dollar hardly seems inappropriate under those circumstances. In Governor Bernanke’s words, "It’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation." He cites, in particular, the 40% dollar devaluation of 1933-34, which he argues was key in transforming a –10.3% deflation rate in 1932 to +3.4% in 1934. Coming from a Fed governor, this can hardly be dismissed as idle chatter.

The common retort to my call for a dollar devaluation is "against what?" Don’t get me wrong; this is not about a dollar that weakens on its own accord. Even though the fundamentals of a massive US current account deficit beg for a depreciation of the dollar, in the end any currency is a relative price. With problems in Japan and Europe perceived to be far more serious than those in the US are, the dollar is unlikely to weaken by the sheer weight of gravity. The dollar comes down, in my view, only if the US makes a conscious effort to alter the rhetorical aspects of its "strong dollar policy." It still amazes me how important the words of senior public officials are in shaping currency fluctuations. Former US Treasury Secretary Robert Rubin mastered the art of talking up the dollar from its record lows hit in the spring of 1995. Therein lies the key to a weaker dollar. If Secretary O’Neill were to publicly disavow America’s so-called strong dollar policy, and if the Fed were to validate such a rhetorical shift with an unexpected easing of monetary policy, I am convinced that the dollar would fall sharply in a very short period of time. Such an outcome could be expected, in my view, irrespective of fundamental weakness in Japan or Europe.

Despite public disclaimers to the contrary, the Fed has made it abundantly clear that it now views the chances of deflation as high enough so that it must treat such an outcome as its central case. Why else would it have eased so aggressively on 6 November? Why else would its senior representatives now be out front in discussing nontraditional deflationary remedies? And why else would the US central bank dare mention the dollar-devaluation option?
Source: Morgan Stanley Global Economic Forum

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