Yesterday, even if he never uttered the word, he made it clear that the Fed is fighting deflation. He also made it clear that they are losing the battle.
From the Fed statement:
Inflation has been running below the Committee’s longer-run objective . . .
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term . . .
The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal . . .
Voting against the action was Eric S. Rosengren, who believes that, with the unemployment rate still elevated and the inflation rate well below the federal funds rate target, changes in the purchase program are premature until incoming data more clearly indicate that economic growth is likely to be sustained above its potential rate . . .
From his press conference following the statement, I heard him say three important things:
He referred to "inflation that is too low" rather than use the word deflation.
He added, "We take this very seriously."
And he said the Fed "hopes" that the inflation rate recovers.
There was blood in the water but no sharks in the room, only journalists who stood in awe of the Fed and politely side-stepped the issue at hand: that the Fed is failing.
Yes, asset prices are up. But money velocity is down. To be more specific, it's cratering.
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| To the Fed, nothing else matters except for this chart. |
The problem is the Fed can't force you to borrow. The Fed can't force you to spend. Even though the government thinks it can force you to buy insurance, the unintended consequence is that you may spend less elsewhere to cover increases in insurance premiums you thought were going to be cheaper.
All of this is deflationary.
Just because the pundits don't think so doesn't mean crack.
And as consumers, borrowers, lenders, and producers pull back and change their behaviors, deflation becomes a self-reinforcing psychological state.
That is why deflation is that which should not be named.
It was not mentioned once in the Fed statement. I did not hear it mentioned in the press conference either.
Greenspan never said the word, referring to it only as "an unwelcome fall in the rate of inflation."
Only Ben's infamous "helicopter" speech in 2002 attempted to spell it out. This is also where, unfortunately, he laid his cards on the table for all to see. Cherry picking his logic reveals a lot of theory, while yesterday showed those theories are coming up short.
. . .
Deflation: Making Sure "It" Doesn't Happen Here
The Federal Reserve Board
November 21, 2002
(excerpts with emphasis added)
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 basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place.
But suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed's policy instrument--the federal funds rate--were to fall to zero. What then?
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.
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning.
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.
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.
I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.
. . . .
Yes, I have cherry picked the speech. Click the link at the beginning to read the entire thing. But in my opinion, the crux of his strategy is right here:
". . . try to stimulate spending by lowering rates further out along the Treasury
term structure--that is, rates on government bonds of longer maturities."
This is simple. Keep your eye on 10-year and 30-year yields. If yields continue to rise, it's game over. The Fed will have lost.
The current narrative is that "rates are rising for the right reasons."
However, rates can also rise because investors demand more interest for their risk.
Or because they fear default, as was evidenced in the European sovereign debt crisis.
Also, no one else may be mentioning the word deflation (in fact the Japanese government dropped it from its economic report for the first time since 2009) but gold is. It has broken through $1200 which is odd behavior for a commodity that is supposedly so inflation focused.
Maybe it's not odd behavior. Maybe it's just another clue.
As for the S&P, a new high should be a sure thing, so if it doesn't happen . . . if yesterday's lows should break, take note of that too.
As for Bernanke's successor, it's too soon to know how Janet Yellen will deal with the word deflation. But she'll likely have ample opportunity for practice.
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