Deflationary Decade? Fed Prepares Vacuum Cleaners

Are prices for consumer goods and services going into free fall over the next few years? Is deflation the likely scenario as record-level declines in commodity prices and government bond yields seem to suggest? Not if the Federal Reserve has anything to do with it.

The Fed has never increased bank reserves as much as it has in 2008. The previous high, was in 1934 when they rose by 57%. No doubt this stimulus played a role, says Northern Trust economist Paul Kasriel, in boosting real GDP growth from 1934 to 1937 by nearly 10% annually on average. The CPI increased in 1934, 1935, 1936 and 1937 by 3.5%, 2.6%, 1.0% and 3.7%, respectively. After the Fed began priming the pump, inflation did occur in the 1930s.

In 2008, the year-over-year increase in November 2008 in bank reserves was 600%, about ten times the previous all-time high in 1934. “The Fed’s seasonally-adjusted net acquisition of assets – primarily securities, commercial paper and loans to financial institutions – represented 100% of the seasonally-adjusted total borrowing by the U.S. non-financial sector in the third quarter of 2008,” writes Kasriel. In previous post-war recessions, this percentage rarely exceeded 20%. And more purchasing of government debt is likely to come when the Obama administration launches its massive stimulus package in early 2009.

There could be some price deflation in 2009 but if 1934 “is any guide, the Fed, starting in 2010, may have to invest in industrial size vacuum cleaners to start sucking up large quantities of credit that it had previously created!” Kasriel concludes.