The Future Actions of The Federal Reserve And US Gov't Are Known

By: Mick P | Tue, Apr 8, 2008
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An Occasional Letter From The Collection Agency

Presents

An interpretation of The Deflation Bias and Committing to Being Irresponsible by
G B Eggertsson

Introduction.

This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind.

I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future.

I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed.

Background.

Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future.

The Federal Reserve Makes a Choice.

We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome.

To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward.

Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view).

Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:

Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:

As GB Eggertsson put it:

If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke's apology the first signpost on his intended path.

Many attribute Bernanke with the nickname "Helicopter Ben" in reference to remarks he made in a speech about how to combat deflation. It is oft used by those who rail against inflation to paint Bernanke as an inflationist. However, this is misplaced. Bernanke was in fact quoting Friedman. What many don't realise is that there is an assumption the Friedman was invoking Keynes in this approach. This isn't true. Keynes did not believe such an approach could work with low nominal interest rates whereas Friedman believed that changes to both fiscal and monetary policy could allow government control of prices.

Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system.

However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced.

Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:

At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.

As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.

The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.

Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow).

Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures).

However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:

Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:

As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk.

It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.

Since 2000:

Since mid 2007:

I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow).

The Future

We now turn our attention to the future. To read the rest of The Occasional Letter, click here.

 


 

Mick P

Author: Mick P

Mick P (Collection Agency)
About Collection Agency

An Occasional Letter From The Collection Agency in association with Live Charts UK.

For some years now I have written an ongoing letter, using macro-economics, to try and peer into the economic future 6 to 18 months ahead. The letter was posted on a financial bulletin board to allow others discuss its topic.The letter contains no recommendations to buy or sell, indeed I leave that to all the other letters out there and to the readers own judgement. The letter is designed to make us all think about what may be coming, what macro trends are occurring and how that will affect future trends and how those trends will filter down to everyday life and help spot weak or strong areas to focus on for trading or investing.

To contact Michael or discuss the letters topic E Mail mickp@livecharts.co.uk.

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