Fundamentally, 2.0% 10-year Treasury yields (^TNX, TLT) can only be explained in terms of expectations of a 1930's U.S. Great Depression-type scenario coupled with deflation. Similarly, such low yields might be justified by expectations of a Japan-style “muddle-through” debt-deflation scenario of drawn out stagnation and low-level deflation.
But how likely are such fundamental scenarios for the contemporary U.S.?
So, why do markets appear to be discounting depression-like debt-deflation scenarios?
This can only be explained by the fact that markets have short memories. At the present time, the U.S. bond market is suffering through a kind of collective panic-induced amnesia.
In this article I would like to review for readers the precise words of Fed Chairman Ben Bernanke. I think it is virtually impossible for any individual to be clearer than Bernanke has been regarding what his response would be to scenarios of debt-deflation. And there is no question that such responses would be effective in preventing depression and associated deflation – albeit at the risk of high inflation.
Bernanke's Description of the Problem
Before moving on to a description of available Fed tools to combat debt-deflation, it will be useful to see how Bernanke frames the problem from an intellectual point of view, and how he compares the situation in the contemporary U.S. with past historical experiences in the U.S. and other countries. For example:
…Some have expressed concern that we may soon face a new problem - the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation - a decline in consumer prices of about 1% per year - has been associated with years of painfully slow growth, rising joblessness and apparently intractable financial problems in the banking and corporate sectors….
…(T)he consensus view is that deflation has been an important negative factor in the Japanese slump.
So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small….
Why does Bernanke perceive the risk of deflation in the U.S. to be so small? Bernanke first lists certain structural strengths of the U.S. economy that he felt distinguished it from the pre-1929 US or Japan in the 1990s. He then goes on to the real focus of his speech:
The second bulwark against deflation in the United States, and the one that will be the focus of my remarks, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation ... I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.
... Accordingly, I want to turn to a further exploration of the causes of deflation, its economic effects, and the policy instruments that can be deployed against it.
Absolutely central to any understanding of how Bernanke conceives of combating deflation is his very clearly stated view regarding the fundamental cause of deflation:
… The sources of deflation are not a mystery. 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. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending - namely, recession, rising unemployment, and financial stress.
Please keep this in mind. Bernanke sees inadequate aggregate demand or aggregate spending as the fundamental cause of depression and deflation.
How the Fed Can Definitely Prevent Depression and Deflation
Bernanke goes on to describe how the Fed can definitely prevent the sort of debt-deflation experienced during the Great Depression or in contemporary Japan.
As it turns out - and as Bernanke makes it abundantly clear - the Fed has no shortage of means to combat depression and associated deflation. Indeed, Bernanke describes Fed “ammunition” with the confidence of a general reviewing a modern arsenal prior to going to battle with unarmed savages. He discusses the central bank’s fire power with the type of enthusiasm and verve that is reminiscent of a kid describing a battle waged in an action-packed video game. Bernanke describes, in glowing terms, a kind of dystopia that only a central banker could dream about.
… 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. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. ... However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will… turn to policy measures that the Fed and other government authorities can take if ... deflation appears to be gaining a foothold in the economy.
…suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed's policy instrument--the federal funds rate--were to fall to zero. What then?
As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero - its practical minimum - monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
... If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
Bernanke goes on in his speech to rattle off a dizzying array of ways that the Fed can inject “printed” money into the system that I will review briefly:
1. Lower the Fed Funds rate to zero. This effectively lowers the banks’ cost of funding to zero. This will presumably stimulate credit creation, spending on goods and services and concomitant expansion of the money supply.
2. Purchase long-term Treasury Bonds. The objective would be to lower rates far out on the Treasury term structure. This will presumably lower interest rates throughout the economy as Treasury yields serve as a reference yield. This is essentially the sort of QE employed with QE1 and QE2.
3. Rate caps. This involves the announcement of explicit ceilings on rates along the yield curve. This requires unlimited authority to purchase Treasuries in order to keep yields at the targeted rates. Bernanke speaks approvingly of a 1951 experience by the Fed with bond-price pegging.
4. Purchases and/or rate caps on agency debt.
5. Purchase of U.S. private debt securities. The Fed does not have authority to purchase private securities directly, but it could work with banks to achieve this objective. It would do so by offering guaranteed fixed rate 0% financing for banks for the duration of the securities purchased.
6. Purchase of foreign debt securities. Bernanke finds this option for injecting money into the economy as quite powerful as “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.” Folks in Europe, are you listening?
7. Purchase of equities on domestic and/or foreign stock markets.
8. Devaluation of U.S. Dollar. The U.S. Fed can intervene in currency markets purchasing and hoarding foreign currencies with newly minted U.S. dollars. Bernanke speaks admirably of FDR’s success with this policy 1933-1934, remarking that “it ended the U.S. deflation remarkably quickly.”
9. Accommodation of fiscal deficit deficits. Bernanke likens Fed-enabled deficit spending through tax cuts or direct spending to Milton Friedman’s famous “helicopter drop” of money onto an economy.
As if he had not been clear enough already, Bernanke concluded the referenced speech with the following remarks.
Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of ... the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold.
I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.
Have you got the message yet, dear reader? Have you read Bernanke’s lips?
No depression. No deflation. Period.
Inflation? If that is the price that must be paid to avoid depression and associated deflation, then it is clear that Bernanke is willing to risk it. The academic and policy consensus reflected in this speech is that inflation is not desirable – but it is much preferable to depression and associated deflation.
Thus, dear reader: Please paste this document onto your bathroom mirror, your refrigerator and on the wall in your office, so that next time you start worrying about debt-deflation and are tempted to purchase long-dated Treasury securities, you can assure yourself that the Fed will not allow debt deflation to occur. And furthermore, you may be persuaded that a 2.00% yield on U.S. Treasury bonds is not at all attractive given the nature and likely sequence of inflationary policy responses by the Fed in responses to any hint of depression and/or deflation in the U.S. economy.
The Fed has expended the first two pieces of firepower on Bernanke’s list of central bank weapons to combat depression and deflation. But as this article should make clear, the Fed has merely been warming up and playing “patty-cake,” thus far. The first two options on Bernanke’s list of ammunition are the warfare equivalents of rocks and slingshots. The real guns and even nuclear armament have not even been dusted off yet.
In fact, going through that list of Fed ammunition and fire-power makes me almost want to go out and play an action video game.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT and long TBT and SBND.