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Deflation or Inflation: Will Helicopter Bernanke Come Flying to the Rescue?
The Federal Reserve Bank Is Switching Gears from Protecting Against Inflation to Protecting Against Deflation

By Editorial Staff Tue, 21 Sep 2010 18:00:00 ET

While skillfully avoiding the use of the term, the Fed was sending an unmistakable message that its gearing up to fight the deflation threat.

Translation: Watch out, below! Here comes more quantitative easing, which means the Fed will create more money on its books and start buying up banks' bad loans in exchange for more money to lend.

Get Prechter's full argument for the deflationary scenario in his comprehensive ebook on the topic, The Guide to Understanding Deflation. Click here -- the ebook is free.

But the Fed can only go so far with this policy, as Robert Prechter explains in chapter 13 of his 2002 New York Times best-seller, Conquer the Crash.

The Fed’s Final Card

The Fed used to have two sources of power to expand the total amount of bank credit: It could lower reserve requirements or lower the discount rate, the rate at which it lends money to banks. In shepherding reserve requirements down to zero, it has expended all the power of the first source. In 2001, the Fed lowered its discount rate from 6 percent to 1.25 percent, an unprecedented amount in such a short time. By doing so, it has
expended much of the power residing in the second source. What will it do if the economy resumes its contraction, lower interest rates to zero? Then what?

Why the Fed Cannot Stop Deflation

Countless people say that deflation is impossible because the Federal Reserve Bank can just print money to stave off deflation. If the Fed’s main jobs were simply establishing new checking accounts and grinding out banknotes, that’s what it might do. But in terms of volume, that has not been the Fed’s primary function, which for 89 years has been in fact to foster the expansion of credit. Printed fiat currency depends almost entirely upon the whims of the issuer, but credit is another matter entirely.

What the Fed does is to set or influence certain very short-term interbank loan rates. It sets the discount rate, which is the Fed’s nominal near-term lending rate to banks. This action is primarily a “signal” of the Fed’s posture because banks almost never borrow from the Fed, as doing so implies desperation. (Whether they will do so more in coming years under duress is another question.) More actively, the Fed buys and sells overnight “repurchase agreements,” which are collateralized loans among banks and dealers, to defend its chosen rate, called the “federal funds” rate. In stable times, the lower the rate at which banks can borrow short-term funds, the lower the rate at which they can offer long-term loans to the public. Thus, though the Fed undertakes its operations to influence bank borrowing, its ultimate goal is to influence public borrowing from banks. Observe that the Fed makes bank credit more available or less available to two sets of willing borrowers.

During social-mood uptrends, this strategy appears to work, because the borrowers — i.e., banks and their customers — are confident, eager participants in the process. During  monetary crises, the Fed’s attempts to target interest rates don’t appear to work because in such environments, the demands of creditors overwhelm the Fed’s desires. In the inflationary 1970s to early 1980s, rates of interest soared to 16 percent, and the Fed was forced to follow, not because it wanted that interest rate but because debt investors demanded it.

Regardless of the federal funds rate, banks set their own lending rates to customers. During economic contractions, banks can become fearful to make long-term loans even with cheap short-term money. In that case, they raise their loan rates to make up for the perceived risk of loss. In particularly scary times, banks have been known virtually to cease new commercial and consumer lending altogether. Thus, the ultimate success of the Fed’s attempts to influence the total amount of credit outstanding depends not only upon willing borrowers but also upon the banks as willing creditors.

Economists hint at the Fed’s occasional impotence in fostering credit expansion when they describe an ineffective monetary strategy, i.e., a drop in the Fed’s target rates that does not stimulate borrowing, as “pushing on a string.” At such times, low Fed-influenced rates cannot overcome creditors’ disinclination to lend and/or customers’ unwillingness or inability to borrow. That’s what has been happening in Japan for over a decade, where rates have fallen effectively to zero but the volume of credit is still contracting. Unfortunately for would-be credit manipulators, the leeway in interest-rate manipulation stops at zero percent. When prices for goods fall rapidly during deflation, the value of money rises, so even a zero interest rate imposes a heavy real cost on borrowers, who are obligated to return more valuable dollars at a later date. No one with money wants to pay someone else to borrow it, so interest rates cannot go negative. (Some people have proposed various pay-to-borrow schemes for central banks to employ in combating deflation, but it is doubtful that the real world would accommodate any of them.)

When banks and investors are reluctant to lend, then only higher interest rates can induce them to do so. In deflationary times, the market accommodates this pressure with falling bond prices and higher lending rates for all but the most pristine debtors. But wait; it’s not that simple, because higher interest rates do not serve only to attract capital; they can also make it flee. Once again, the determinant of the difference is market psychology: Creditors in a defensive frame of mind can perceive a borrower’s willingness to pay high rates as desperation, in which case, the higher the offer, the more repelled is the creditor. In a deflationary crash, rising interest rates on bonds mean that creditors fear default.

A defensive credit market can scuttle the Fed’s efforts to get lenders and borrowers to agree to transact at all, much less at some desired target rate. If people and corporations are unwilling to borrow or unable to finance debt, and if banks and investors are disinclined to lend, central banks cannot force them to do so. During deflation, they cannot even induce them to do so with a zero interest rate.

Thus, regardless of assertions to the contrary, the Fed’s purported “control” of borrowing, lending and interest rates ultimately depends upon an accommodating market psychology and cannot be set by decree. So ultimately, the Fed does not control either interest rates or the total supply of credit; the market does.

Tags: deflation, U.S. Federal Reserve (the Fed)

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