The Fed, Part IV: Bernanke on Deflation.—

In 2002, before he was named Federal Reserve Chairman, Ben Bernanke gave an interesting talk on the dangers of deflation:

With inflation rates now quite low in the United States, however, 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 percent per year--has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors.

To be clear, Bernanke is not talking about a simple drop in investment assets, but a general deflation in consumer prices as well.

Bernanke then outlined how the Fed can avoid deflation:

[T]here are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation.

First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero. Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times.

Second, the Fed should take most seriously--as of course it does--its responsibility to ensure financial stability in the economy. Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks.

Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates . . . . By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.

As I have indicated, I believe that the combination of strong economic fundamentals and policymakers that are attentive to downside as well as upside risks to inflation make significant deflation in the United States in the foreseeable future quite unlikely.

Bernanke's 2002 analysis appears to be very sound.

The Fed, Part III: Poole Says `Real Economy' Unhurt by Subprime Collapse.--

Federal Reserve heavyweight Bill Poole gave an interview to Bloomberg:

William Poole, president of the Federal Reserve Bank of St. Louis, said there's no sign that the subprime-mortgage rout is harming the broader U.S. economy, and an interest-rate cut isn't yet needed.

"I don't see any impact as yet on the real economy or on the inflation rate," he said in an interview in the bank's boardroom. "Obviously, there could be an impact, but we have to rely on some real evidence."

Barring a "calamity," there is no need to consider an emergency rate cut, Poole said. His comments were the first by a Fed official since the U.S. central bank joined counterparts in Europe and Asia to inject emergency funds after a surge in money- market rates. The Fed has added $71 billion of reserves in the past five trading days. Poole, 70, said businesses have maintained their hiring and investment plans and banks have sufficient capital to weather the credit-market turmoil. The St. Louis Fed chief stressed that the best course is for policy makers to assess the latest economic data when they next meet Sept. 18. The comments contrast with the certainty that traders put on a rate cut next month.

"If the data confirm the market's view that the economy is sagging, we'll have to decide whether to share that view," said Poole, who votes on the rate-setting Federal Open Market Committee this year. He cited the monthly jobs, retail sales and industrial production reports as key gauges he'll be watching.

The yield on the September federal funds futures contract closed at 4.95 percent today, indicating at least a quarter-point reduction in the Fed's target. The benchmark two-year Treasury note yielded 4.29 percent, the furthest below the Fed's benchmark since 2001, when policy makers were lowering rates.

"There's no way the Fed is going to reduce interest rates before the meeting," said former Fed Governor Lyle Gramley, now senior economic adviser at Stanford Group Co. in Washington. "Bill is just being realistic that we haven't seen anything going on in markets yet that would warrant that kind of action."

Poole acknowledged that the credit-market turmoil will "stretch out" the "adjustment" in the housing industry. He said he couldn't predict how long the downturn will last.

The upheaval in credit markets was caused by deepening losses on securities backed by U.S. subprime mortgages. BNP Paribas SA, France's biggest bank, shocked investors Aug. 9 when it halted withdrawals from three funds just a week after its chief executive officer said the lender wasn't at risk. . . .

Poole rebutted comments from some Fed watchers that the central bank may be out of touch with market developments. The criticism followed comments the St. Louis Fed chief made to reporters on July 31 that the slump in stocks was "a typical market upset."

"No one has called up and said the sky is falling," Poole said today. "As I talk to companies, their capital spending plans are intact." . . .

[Referring to the housing market problems, Poole said:] "From experience, these things don't go on forever."

Poole said he didn't regret that the Aug. 7 statement retained a bias against inflation. He also said that while consumer price gains are "moving in the right direction," the "job is not done."

Inflation has slowed for four straight months under the Fed's preferred gauge, which excludes food and energy costs. . . .

Poole, who plans to retire next year, is a former economics professor at Brown University . . . .

Sometimes, as with the bursting of the bubble in 2000-2002, there may be little that the Fed can do to prevent the reduction by half of many people's pensions. Other times, by looking realistically at the relative threat of serious inflation v. recession and setting interest rates where they should be to continue moderate growth by limiting the spread of a credit crunch, the Fed might be able to prevent a US recession or soften its length or depth.

As a non-economist, I recognize that I lack not only the Fed's knowledge of the details of the US economy, but the expertise to evaluate that information with any confidence. I just hope that the Fed knows what it's doing.

Next: The Fed, Part IV: Bernanke on Deflation.

The Fed: Part II: What's Goin' On?

In Part I of this morning's posts on the Federal Reserve, I pointed out that, since World War II, significant housing price drops have always been followed by recessions or been coincident with them.

The Federal Reserve's initial response to the subprime mortgage crisis was to claim last spring that it seemed likely to be "contained":

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely.

As unlikely as that seemed to me at the time, I hoped that the experts at the Federal Reserve knew what they were talking about.

When Cerberus was unable to sell its paper to fund the Chrysler deal, the deal went through anyway by extending the bank bridge loans, but the stock market realized that subprime problems had spread to the market for commercial paper and private equity funding. Then it was revealed that the market for mortgage-backed securities was mostly not functioning, which made it difficult for mortgage lenders to raise money by selling off their existing mortgages. High-flying hedge funds and European banks started revealing problems. Unlike in downturns earlier in the year when precious metals, oil, and basic materials stocks tended to rally, in recent downturns harder assets (and stocks reflecting them) started doing poorly as well.

In the face of a credit crunch that was clearly not being contained, nine days ago the Federal Reserve released its decision on interest rates:

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy. Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures. Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.

Frankly, I was surprised.

Data released in the last few weeks suggest that US inflation is moderating (running only 2.2% year over year) and job growth is slightly softer than expected, giving the Fed plenty of room to lower interest rates. Seemingly informed commentators report that dozens of European and Asian banks probably have nontrivial amounts of subprime paper in their portfolios. The commercial paper market is so frightened that concerns have been raised about whether money market funds can maintain their $1 asset value. Although most commentators say that they will be able to do so, many institutions are reported to be dumping even quality commercial paper in favor of treasury bills and notes in a flight to quality.

It would seem that with housing prices falling, commodity prices falling, stock prices falling, commercial paper prices falling, and CDO prices collapsing, net deflation (rather than inflation) would seem to be the bigger risk. And, of course, the author of the leading policy paper on deflation is none other than Federal Reserve Chair, Ben Bernanke (2002, discussed in Part IV posted below).

In my genuine ignorance, it seemed to me that, even if the Federal Reserve Board had acted promptly in late July or at its August meeting last Tuesday, avoiding a US recession (or a near recession) would be a tough task for the Fed. In a global economy, the Fed has much less control than it used to. By deciding to wait until the subprime mess degrades not only the inputs for economic growth, but economic growth itself, the Fed may decrease the chances that it will ultimately succeed.

Next: The Fed, Part III: Poole Says `Real Economy' Unhurt by Subprime Collapse.

The Fed, Part I: Avoiding Recession?

I confess to being puzzled by the Federal Reserve's actions in recent weeks, as well as by the assumptions of even most of the Fed's public critics that we are not likely to go into a recession. Without an economics degree, I may well be misunderstanding the evidence or the Fed's duties. I had begun writing a series of long posts on the Fed two weeks ago, but decided to wait to publish them to see if the Federal Reserve would lower interest rates before I waded into such a difficult policy thicket.

I had always thought that part of what turned financial hardships into recessions and recessions into depressions was severe restrictions in the willingness of financial institutions to lend and borrow money. For example, after the 1929 stock market crash, banks and brokerage houses reformed their excessively easy lending practices, leading to a massive contraction in the supply of money and its velocity.

Over the last year, we have had four straight quarters of lower prices on the sale of existing single-family homes. While price declines so far have been modest, the rising inventory, tighter lending standards, increasing foreclosures, and substantial non-price seller concessions suggest that nominal prices may not fully reflect the extent of the price decline and that things could get much worse in the housing market before they get better.

Since World War II, there have been three sharp housing price declines (in real dollars):

the 1947-48 housing price drop, preceding the Nov. 1948 -- Oct. 1949 recession,
the 1979-82 housing price drop, preceding the July 1981 -- Nov. 1982 recession (and also coincident with the Jan.-July 1980 recession), and
the 1989-91 drop, associated with the July 1990 - March 1991 recession.

With the ridiculously easy lending standards of the housing boom in the 2000s, an impending housing crisis was almost unavoidable, as Robert Schiller argued in March 2006.

Schiller presents housing price data through 2005 in real, inflation-adjusted dollars:

(click twice to enlarge)

The Federal Reserve, therefore, was and is faced with an extremely difficult challenge: to prevent a severe housing crunch from having its usual effect: driving the US economy into a recession, as the three biggest housing crunches since World War II have done.

For more on Federal Reserve policy, go to The Fed: Part II: What's Goin' On?

Fed Cuts Discount Window Rate.

At about 8:15 ET Friday morning, the Federal Reserve reduced the discount window rate, which was 6.25% (a 1% penalty over the stated 5.25% Fed Funds rate) to 5.75% (a .5% penalty) for borrowing at the discount window. The most heartening thing about it is the reversal in worrying much more about the economy:

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

Oddly, Bill Poole, who was saying just a couple days ago that there was no reason for a cut, is not listed as voting either for or against today's Fed move. It was just reported on CNBC that he had a scheduling conflict.