With consumer prices rising so little that they look like a deflating soufflé, Fed Chairman Ben Bernanke now has publicly faced the fact that the Fed must fight deflation rather than the central bank's old nemesis, inflation. At a meeting in Jackson Hole, Wyo., this week, he said what he had to say -- that deflation is "not a significant risk for the United States at this time." Nonetheless, in time-honored Fed speak, he added that the Federal Reserve "will strongly resist deviations from price stability in the downward direction.”
As the New York Times reporter commented in the August 27, 2010, report, "It was his most robust statement to date that the Fed would do its part to avoid a Japanese-style deflation from taking hold."
Watch out, below! Here comes more quantitative easing, which means that the Fed will create more money on its books and start buying up banks' bad loans to provide them with more money to lend. But the Fed can only go so far with this policy, as Bob Prechter explains in an interview he did with Justin Brill, managing editor of The Daily Crux, a financial daily digest website.
* * * * *
Excerpted from a transcript of the interview, which appeared in the June 2010 edition of The Elliott Wave Theorist, by Robert Prechter
The Daily Crux: But, ultimately can’t the Fed simply “print” money if it appears deflation is starting to win? The “drop money from helicopters” analogy you mentioned earlier? Wouldn’t that prevent outright deflation and ultimately lead to inflation or even hyperinflation as the dollar is devalued?
Robert Prechter: To begin with, the printing analogy is flawed. The Fed does not operate a press, as the government of Zimbabwe did. It creates new money only when it buys IOUs. This may seem to be a distinction without a difference, but it’s actually very important. These IOUs are the Fed’s assets, and it doesn’t want worthless assets backing its notes.
Even if the Fed were to monetize every dime of currently outstanding, dollar-denominated debt, it would create no net inflation. The money-plus-credit supply would be the same. And price levels — especially for investments — are based on the total of monetary assets, not just base money.
Even so, there is no way that the Fed will buy up the entire world’s stock of lousy IOUs. It has always wanted pristine assets on its books. Remember, it didn’t buy Fannie and Freddie’s IOUs until it got the Treasury to guarantee them.
Then there is the so-called moral hazard — not that the Fed cares about morality — meaning that if the Fed were to begin buying everyone’s IOUs, people would immediately issue more IOUs as fast as they could and sell them to the Fed. It couldn’t keep up with the volume.
But these scenarios are fantasies. In reality, self-preservation will eventually motivate the Fed just as it motivates every other institution. Buying too many worthless assets would cause the Fed’s self-destruction, and I think it will balk at going that far.
The Daily Crux: OK, so you don’t think the Fed will go that far. But what if the government got involved and tried to inflate its way out by issuing massive amounts of Treasury bonds to the Fed? Wouldn’t that create inflation?
Robert Prechter: If the government tried to do that, bond holders would get spooked, and interest rates would go up and stay ahead of the printing. At the same time, other credit prices — municipal, corporate and consumer — would implode. When the supply of credit is far bigger than the supply of money — and it is by a huge margin — the value of old credit can contract faster than new bonds can be printed. The net result would still be deflation.
But this is not the most likely scenario. Have you noticed that even the Fed chairman has been telling Congress it needs to stop spending and borrowing? The Fed doesn’t want this to happen any more than other creditors do.
If the Treasury’s interest rates do soar, it will not likely be due to inflation fears but to fear of government default. If the government is forced to pay higher and higher rates, it will become a black hole for money. Spiraling Treasury rates would suck money from other sources, causing banks, municipalities and companies to fail, ruining all of their debts, which would be deflationary.