Archive for the ‘Deflation’ Category

From the Financial Times:


The point of the FT article was to describe how it is extremely difficult for the private sector to deleverage, or reduce debt levels, during periods of falling prices…As the charts show, the US is witnessing debt balloon to levels not seen since the 1950’s (as a percentage of GDP), while asset prices have fallen precipitously.

As the author describes;

It has long been argued that the US could not suffer like Japan. This is wrong. It is true the US has three advantages over Japan: the destruction of wealth in the collapse of the Japanese bubble was three times gross domestic product, while US losses will surely be far smaller; US non-financial companies do not appear grossly overindebted; and, despite efforts by opponents of marking assets to market, recognition of losses has come far sooner.

Basically, our situation is more similar to that of Japan circa 1990-2005 than we had anticipated – not to mention some  economic characteristics which are considerably less desirable (a global recession, leaving little room for other countries to pick up the slack in our budget/trading deficit by buying our debt and consuming our exports).

Surprisingly, part of the reason the author included all of this background was to advocate for a bigger stimulus package, not to be depressing.

Unfortunately, there is no discernible solution to the problems brought up in this article, other than the old “we’ll have to tough this one out” analysis:

The bigger point, however, is not that the package needs to be larger, although it does. It is that escaping from huge and prolonged deficits will be very hard. As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment.

There will be a Part II to this author’s column in next week’s FT, if at all interested.

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There was a lot of news to write about on Monday…Seriously.

Besides Arnie calling California’s situation “a fiscal emergency”, the Dow crashing 680 points, more Goldman bonus cuts, Oil falling below $50…oh, and of course. It’s finally an official recession. However some of the biggest news comes from the FED concerning alternative measures to adding liquidity to the markets.

When the FOMC “cuts” interest rates, they do so by buying short-term treasury bills. This method of adding liquidity into the economy is hampered if there is no interest rate to “cut”.

3-Month 0.000 03/05/2009 0.04 / .04 0 / .000
6-Month 0.000 06/04/2009 0.32 / .44 -0.1 / -.102

This pickle we find ourselves in is known as a “liquidity trap”, where virtually all of the government’s supply of T-bills have been met with excessive demand (in this case, this is the quantification of a flight to safety).

What really set the markets off today (at least the bond market) was something Ben Bernanke mentioned in a Q & A held in Austin, Texas; when confronted with this very issue of a liquidity trap, he pointed out that the FED was not constrained to traditional metrics of expanding the money supply, but referenced a speech he delivered back in 2002, the last time the U.S. went through a deflation scare – one in which, like today, we straddled very low inflation coupled with the fear of slowing aggregate demand. Here are some excerpts from his 2002 speech:

“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.”

“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.”

Just to keep things in perspective with the crash of 1987….today’s drop wasn’t THAT bad.

1-Month Timeframe

10-Year Note, 1-Month Timeframe

10/16/87 - 11/16/87

10-Year Note, 1-Month Time Frame: 10/16/87 - 11/16/87

Now it was this idea, his non-traditional method of providing liquidity in a ZIRP environment, where the yields on 10-year notes began to tank:

“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.”

A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.”

Keep in mind that the above quoted section is from 2002, not today…though it’s funny how relevant it is.

It’s also interesting how the bond market reacted like this was some sort of new idea; Bernanke has always maintained the reputation of being an expert on the Great Depression, and his ideas for monetary policy in a zero-interest-rate environment have been public for quite some time (6 years, to be exact…I suppose the efficient markets hypothesis has selective cognition).

Either way, this would be a ground breaking policy: Bernanke’s mention of the strategy in his speech today pushed the yield on 10-year Treasuries down 22 basis points and the 10-year’s yield to 2.70%, its lowest since 1955.

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I’ve been preparing for the “FED Challenge” which takes place on November 5th, down in Baltimore. If we win this first   round, we’d go to the regional competition, and then (improbably) to the national competition, which was won by Harvard last year. I thought I’d post the general points I’m going to make, but keep in mind, as the FOMC, we only make a decision about the Federal Funds target rate, nothing concerning a bailout package.

1. Keeping rates low for an extended period of time will:

o Steepen the yield curve; sign of future economic prosper, and a favorable development for the banking system.

o Should lower the interest rates on ARM’s pegged to prime.

o In time, as panic subsides, LIBOR will drop – many loans are pegged to LIBOR.

2. Today, the Federal Funds rate has become second fiddle to the unprecedented action taken by the treasury, and our Federal Board of Governors to insure commercial paper markets.

3. Fed target rate may be at 1%, but the effective rate is at .3% from the new initiatives of paying interest on bank reserves. This has rendered the targeting of the funds rate somewhat less important than before.

4. In terms of Foreign Exchange Markets, despite our low interest rates, the dollar should remain strong relative to the Euro nations and EM, since they are very unstable – in part due to the nationalization of much of their banking system. While a stronger dollar will likely hamper the 5.9% increase in real exports we saw in the 3rd quarter, the dollar strength should place a ceiling on commodity inflation, since much of the increase in commodities over the summer was tied to a weak currency.

5. Reverting back to 1980 is something that few want to see; the recession was severe, with the economy contracting at a 7.8% pace in the second quarter of 1980. The unemployment rate by November 1982 moved to 10.8%, which thankfully has not been surpassed. This time around, GDP is seen contracting at a pace in a range of 2% to 4% over the next couple of quarters, and unemployment is expected to move up to about 7.5%, or possibly over 8%.

6. A scenario of even greater concern is deflation.

o We have sustained tremendous asset depreciation across all sectors of investment, resulting in an evaporation of wealth. Japan’s period of deflation was sparked by a large price bubble in real estate and equity markets (very pertinent to today…When assets decrease in value, the money supply shrinks, and this is deflationary).

Many worry that this could trigger a downward spiral of falling prices, since aggregate demand would be crippled from lack of disposable income and insufficient access to credit. I, however, do not foresee this happening. Only if the banks hoard the money provided from the TARP could we experience an extinction of liquidity, and possibly lead to deflation. Another worry is that the bailout plan will ignite a period of hyperinflation, since more money is being added to the economy everyday. however this fear may not materialize either, since the cash infusion will ultimately serve as a replacement for money which was lost in aggregate investment.

Given all of this information, we should leave the federal funds target rate at 1%. As a central bank, we have done as much as possible for the time being – we will need to wait to see how our actions are greeted by the macro-economy. Further, it is not the cost of money which is the problem, it’s the availability. We should not treat the matter of cutting rates below 1% lightly. The FOMC would virtually surrender all monetary policy. We have seen, and continue to see that Japan has been trapped within a period of near zero interest rate policy for over 10 years. Therefore, in order for rates to stay at 1%, we should consider maintaining our position on quantitative easing (flooding commercial markets with liquidity to promote private lending) and reevaluate our stance should economic conditions deteriorate beyond our current expectations.

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