Faisal Humayun's  Instablog

The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, 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 as well as inflation.

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.

Mr. Bernanke further goes on to say that:

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.

My observation on above Comments

At least here, Mr. Bernanke proves that he is a man who keeps his words. Since October 2007, Mr. Bernanke has been running the printing press he talked about in 2002 and has been successful to some extent in making the value of each Dollar go down. I must mention that he is not finished yet and he will do the same in the near future as well.

On the other hand we have U.S. Treasury Secretary Timothy Geithner who is talking about a strong Dollar policy. However, Mr. Bernanke had stated in 2002 that even by threatening to increase the number of Dollar in circulation, one can reduce the value. I think Geithner is trying something similar. Just by projecting that U.S. wants a strong Dollar, he is trying to lift sentiments on the Dollar to some extent.

I would also like to add here that money has three primary functions:

• It is a medium of exchange

• It is a store of value

• and It is a unit of account

Mr. Bernanke, by working overtime in his printing press has ensured that the Dollar is no longer a store of value and a unit of account. I would not be surprised if he wins a Noble Prize for trimming down the functions of money.

Second Formula for avoiding Deflation

Recently, the Fed announced that they would keep interest rates low for an "extended period". If we go back to Mr. Bernanke's speech in 2002, we would get some idea of the intention and objective the Fed is trying to achieve through this statement.


Below is an extract from the speech:

There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. 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).

My Views on this Statement

The Fed has already announced its genuine intentions of keeping interest rates low for a long period. However, Mr. Bernanke likes the second option more then the first. Thus, it would not be surprising to see him implement this policy in the future as well. If the yields on the longer term treasury bonds keep going up (as it has been since December even after debt monetization), then the Fed might fix a upper ceiling for the rates. This would obviously lead to a sell off in the bonds but the Fed is there to buy the bonds and keep the rates fixed at the levels it wants it to be at.

This move would be targeting flooding the markets with Dollars again as the Fed would buy up the bonds and print some more money to pay for that purchase. This, according to Mr. Bernanke should help in preventing deflation and re-start the spending spree (the fall in which lead to deflation).

However, the manipulative ideas and strategies don't end here. The next one is a big of a shocker.

Third Formula to avoid deflation:

To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities.

Thus, the Fed has the power or potential to manipulate privately issued debt securities. At zero interest rates, by giving banks the money, the Fed can purchase private bonds impacting or lowering their yields. Besides making them unattractive, the Fed can also inject more money into the system by this method.

I have no evidence to prove that the Fed is doing this already. But it can't be ruled out as Mr. Bernanke has taken this speech of his seriously and has already implemented some of the measures talked about in the speech.

So, with the power to print any amount of money, the Fed can manipulate or at least try to manipulate many asset classes. I am not sure what this will lead to in the long term. But it surely will not have positive effects. There are discussions and debates for more regulation in the financial system. In my opinion, in order to prevent a disaster, one needs to regulate the Fed. There is an urgent need of more disclosure from the Fed in terms of their policies and actions.

If this is not done then Mr. Bernanke can prove to be a lethal weapon for the Dollar and also for further problems in the U.S. economy. President Obama, by giving Bernanke another four years has ensured that he tries everything he has talked about in this speech and maybe something more.