What's Ben Gonna Do?

Every day the deflation story gets stronger. Almost all of the numbers in the US are pointing in that direction. A slowdown in the EU is a sure thing. Japan is going nowhere. China is a question mark, but even if they do continue growing it will not result in enough Eco. Juice to offset the global deflationary forces.

 I was anticipating a slowdown in the 4th Q. It is now looking more likely that we will fall of a cliff starting July 1st. Extended benefits will be ending. Most states start a new fiscal year and they are all dead dead dead on revenue. Any benefit we got from the census will be in reverse gear. By August 1st approximately 1mm temporary workers will again be out of a job. Housing is falling off a cliff.

The market sees this. The ten-year is at an incredible 3.1%. The last few days of trading in gold has a smell of deflation as well.

Bernanke must be beside himself. He bet the farm to save the economy in 2009. He has done things that no other Fed head as ever contemplated. As betting goes, he is “all in” on this one. He bet the economy, our future solvency and his reputation. In my opinion there is no way he is going to throw in the towel and accept that deflation is inevitable.

Ben spelled out what he would do in the “unlikely” event that deflation became a real threat in his famous 2002 “Helicopter” speech. The full speech is here. This speech has been hashed many times before. Given the news of late it is worth relooking at what Ben had to say. Some excerpts:

Under a fiat money system, a government should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.


Well Ben, we have had ZIRP for two years now. It has made a difference. But zero interest rates have just bought time, not a recovery.

The U.S. government has a technology, called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.


Ben has been running that printing press. QE created $1.75t. It has not had a lasting benefit.

The Fed could stimulate spending by lowering rates further out along the Treasury term structure. There are at least two ways of bringing down longer-term rates:
(I) Fed could commit to holding the overnight rate at zero for some specified period.
(II) 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. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities.


Ben has done (I). As of yet we have not seen (II). For me it is scary that this is his “favorite” approach. That makes this one a sure thing if evidence mounts that we are rolling over. But this does not accomplish much in today’s markets. The 2-year is at 75bp. What is Bernanke going to do? Push that to zero also? He might.

The Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years.


Why stop at 6 years Ben? To make a dent he would have to have the 10-year at 1%. Is that what he has in mind? I think it is a real possibility.

An option would be for the Fed to use its existing authority to operate in the markets for agency debt.


We have done that already in a biblical manner. $1.25 trillion. Three months after the program ended the housing market is falling off a cliff. I would not be surprised if Ben re-established this program. Buying another $1 trillion would not accomplish anything but make the primary dealers rich. But a desperate Ben would do this again in a NY minute.

The Fed might next consider attempting to influence directly the yields on privately issued securities.


Oh boy, this is the beginning of the end. Ben would buy corporate debt. GE would be high on the list; the rest of corporate America would follow. Ben could buy BP bonds. That would solve our problems, wouldn’t it?

The Fed might make 90-day or 180-day zero-interest loans to banks.


Lights out when this happens. Ben will stop at nothing. This option is not far from reality. That said, if this happens the public backlash is going to be vicious.

The Fed has the authority to buy foreign government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.


The “nuclear option” is to buy up the sovereign debts of other countries. This would extend QE globally. In a way we just did this with the opening of $100b in swaps lines to the European central banks. This gives them the wherewithal to buy their debt. The ultimate is when the Fed starts doing it for their own account. I doubt this option is realistic. It would require the approval of the other CB’s. That said, should you see this headline buy lots of canned food and rice. If this step is implemented bread lines will follow.

It's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.


In this case the Fed would attempt to devalue the dollar in order achieve its goals. This of course would just destabilize everything else in the world and would insure a downward spiral in economic activity.

Most of the things Ben spoke of back in 2002 have already been tried (or are now in place) and have not worked. The remaining options do not appear to have much chance of working either. But that does not mean that we will not see these steps.

Ben has already destroyed savers. This is the consequence of his steps. It was not his goal, but he understood fully that savings would have to be penalized. He is in so deep at this point that I believe he will consider anything to protect his reputation in history. The one thing that he did not bring up in the 2002 speech was negative interest rates. While this option sounds ridiculous it can’t be excluded as a possibility. The SF Fed had a paper on this recently. A graph of the “proper” Fed funds rate:


John Hilsenrath at the WSJ also put the idea of negative interest rates on the table in a recent piece. I think the article was from Ben’s lips, into John’s ear and then onto the front page of the Journal.  If Ben has something to say on this matter he should address us all. He should not use a beard to influence public/market thinking.

How could something as crazy as negative interest rates work? Consider this from none other that Harvard economist Greg Mankiw. He had this to say on the subject back in March of 2009:

I can now state the proposed solution: Reduce the return to holding money below zero. Imagine that the Fed were to announce that it would pick a digit from 0 to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.


This bit of lunacy comes from one of our best and brightest economists. Should this (or any other negative % plan) be implemented it would mean that a depression is just a few months away. The last desperate acts would insure that we would fall into a very big hole. We will hear more on these “emergency” measures in the coming months. Should any of them come to pass, be guided accordingly. These steps will only agonize what must come.


 

Black Hole, NASA photo

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