Deflation: Making Sure "It" Doesn't Happen Here

The trend is abundantly clear; the U.S. economy has been slowing for more than six months and is perilously close to contraction.

After growing at a robust 4.1% clip in the last three months of 2011, gross domestic product fell to 2% growth rate in the first quarter, before falling again to 1.5% in the second quarter.

Using monetary policy, the Federal Reserve has made repeated attempts to stimulate the economy and raise it from its listless state. The Fed has held short term rates at a remarkably low level of between 0% and 0.25% since December 2008. It has also purchased nearly $3 trillion worth of Treasuries and housing-related assets to lower long-term interest rates and try to spur the economy.

If these efforts have worked at all, they have so far averted a double-dip recession. Yet, these extraordinary measures have not resulted in an economic recovery. To the contrary, things are getting worse.

Clearly, the economy is contracting, or deflating. Recessions are technically defined by two consecutive quarters of contracting GDP. Though we aren't there yet, the current trend is worrisome. Recessions are, by definition, deflationary. Above all else, the Fed fears deflation; it is harder to control than inflation and once it takes hold, deflation can be crippling.

The U.S. economy is built on a perpetual growth model. Deflation aside, even stagnation is debilitating. Growth is imperative.

The Fed likes inflation because it makes debts easier to repay. But inflation also devalues the money in everyone's pockets and bank accounts.

At a rate of three percent annual inflation, your money loses 30 percent of its buying power over the course of a decade. For example, inflation was 27% from 2000 to 2010. That's a hidden tax on all Americans, young and old, rich and poor. So, inflation is also a pernicious thing.

With that in mind, what follows are highlights from a speech given by Ben Bernanke on Nov. 21, 2002. This is the infamous speech that earned Bernanke the moniker "Helicopter Ben."

As you read the speech, bear in mind that it was given a full six years before the financial collapse, which led to the federal funds rate being reduced to its present level of 0% to 0.25%. It was also four years prior to Bernanke being nominated as chairman of the Federal Reserve.

As you'll see, Bernanke had a plan, a vision and a philosophy — all of which explains what is going on today, monetarily. You can see Bernanke's utter fear of deflation. Concerns about inflation? They hardly exist. In fact, Bernanke makes clear that central banks seek an inflation rate between 1 and 3 percent per year.

Bernanke also outlines the "special problems" that central banks face when the federal funds rate reaches zero due to deflation. This should cause the reader to wonder how bad the problem could become, considering that the rate is already effectively zero. As Bernanke notes, a zero interest rate places a "limitation on conventional monetary policy."

However, in Bernanke's view, even when the interest rate has been forced down to zero, the Fed "has most definitely not run out of ammunition."

There is a singular strategy always at the Fed's disposal, according to Bernanke, providing it "considerable power to expand aggregate demand and economic activity" and allowing it "to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero."

What is that strategy, you are surely asking?

Printing money.

The problem is that printing large sums of money, without any relation to a corresponding increase in the amount of goods and services in the economy, devalues all of the money in circulation.

"By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so," said Bernanke, "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."


Note: The bolded areas are my emphasis. The italicized areas are Bernanke's.

Deflation: Making Sure "It" Doesn't Happen Here

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.

Before going further I should say that my comments today reflect my own views only and are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee.

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.

However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."

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.

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value.

Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern — the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate — the overnight federal funds rate in the United States — and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

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.

There are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation. 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. Central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year.

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.

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.

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.

Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.