While most Fed pundits are focusing on the Arvind Krishnamurthy paper referenced earlier discussing the Fed's "optimal exit" options, another paper, one by Robert Hall of the Hoover Institution and Stanford titled "The Routes into and out of the Zero Lower Bound" may be worth a perusal. The main reason is that while the author admits QE has been largely a failure for the mainstream economy ("the United States and most other advanced countries are closing on five years of flat-out expansionary monetary policy that has failed in all cases to restore normal conditions of employment and output") in part due to a collapse in collateral values, and in part due to no capex spending as we have warned for the past two years, i.e., "the combination of low investment and low consumption resulted in an extraordinary decline in output demand."
However like every true economist his policy response is simple - to double down, or rather "The central danger in the next two years is that the Fed will yield to the intensifying pressure to raise interest rates and contract its portfolio well before the economy is back to normal."
And, again, life every economist, he present the catastrophic deflation strawman as the inevitable outcome should the Fed dare to withdraw ahead of its time (because ignore that as Hall himself admits, the Fed has failed to achieve its policy goals in 5 years - maybe it just needs 10 years, or 15, or 20, or forever). Only this time the Mutual Assured Destruction warning is one not even Hank Paulson come up with on short notice.
The deflation nightmare
So far, inflation has fallen only slightly and remains in positive territory. Fears in early 2009 that rapid deflation might break out and cause the economy to collapse as in 1929 to 1933 proved unfounded, luckily. I have advanced the hypothesis that rampant price-cutting has failed to appear because businesses are in equilibrium and perceive that price-cutting has bigger costs than benefits. If the hypothesis is wrong and businesses are finally responding to five years of slack by cutting prices, the generally optimistic tone of this section could be quite mistaken. The bottom could fall out of the economy as it did in the Great Depression.
Well, since it is the Fed that is now the only cause for the malaise gripping not only the US economy but that of the entire world, and since the more the Fed distorts the systemic equilibrium the more intent it is on doing more distortions in a closed Catch 22 toxic loop, we suppose we should thank Dr. Hall for showing everyone just what the final endgame truly will be. At least, before in one final attempt to stimulate (hyper)inflation the Fed goes all out and destroys the reserve currency status of the dollar.
Because, as we never tire of repeating, no monetary system (or civilization) has ever disappeared due to hyperdeflation. and/or monetary undebasement (maybe the banker class did, but certainly not the civilization). Especially not in a world in which Bernanke's chopper is fueled and ready.