What the Fed Believes

John Mauldin | Thoughts from the Frontline
November 28, 2002

Today we are going to look at a very important speech by new Federal Reserve Governor Ben Bernanke. I think this is one of the more important letters I have written in a while. The speech has received a lot of publicity for some of it's speculations about potential Fed policy. Some seem to find very dire and immediate negative implications in the speech. I, frankly, do not.

However, I do think the speech is important because it gives us insight into the nature of the operational (and visceral) beliefs among the members of the Federal Reserve, and in giving us a roadmap for future Fed actions. It also gives us some hints as to future Fed actions.

But first, a quick look at the Muddle Through Economy. This week we get a lot of good news. The Chicago Purchasing Manager's Index is solidly up, which means the national numbers will be good next week. Housing has bounced back this month. First time jobless claims were down although announced lay-offs are still worrisomely high. Consumer sentiment is edging back up. Business spending is up nicely.

But bank credit card write-offs are up 35.6%, late mortgage payments and foreclosures are up, factory utilization is still an issue as business keeps putting off making new investments. Personal debt is now almost 100% of disposable income.

It seems we grew faster in the third quarter than we had previously though, at a blistering 4%, although a large percentage is automobile related, with most of the rest from government spending. It seems this quarter that the NABE (National Association of Business Economists) is speculating that we will be closer to 1.4% growth. While they are so habitually off it is hard to give them total credence, other economists I do respect seem to be echoing the opinion that this quarter will indeed be slow, perhaps showing as little as 1% growth. No one seems to be forecasting a robust Christmas sales period.

The European Central Bank shows they continue to have no clue, as the headlines today suggest that ECB members are still focused on fighting inflation as Germany is dangerously close to slipping into recession, and the rest of Europe is flowing close on their heels. But Malaysia reports record port shipments, and other parts of the world seem to be moving goods, so world trade is not falling into a black hole.

In short, we continue to be in the Muddle Through Economy. We shall end this year, it seems, north of 2% GDP growth, which is nowhere near the 3.5%-5% (or more) growth most mainstream economists predicted this time last year, as we were supposed to be in a "V" recovery. Nor is it the double dip recession others forecasted. My muddle through conjecture of last January seems to be on target.

Right now, it seems like we will be in this same slower growth cycle for the next few quarters at least. Let us be thankful. Slow growth is better than no growth at all. We could be in Europe or Japan.

This "recovery" has been different from most other periods following a recession. We are in a profitless recovery. And that is why I can predict a slightly growing economy on the one had and on the other maintain we are in a secular bear market. Investors and many analysts seem to think that the good economic news is foreshadowing a recovery of profits. But the good economic news is not in the areas which suggest a recovery of profits. Ultimately, it will be real profits, or the lack thereof, which will drive market valuations.

Now, I want you to keep this thought of a slow growth, Muddle Through Economy in the back of your mind as we analyze Bernanke's speech. It will prove to be the key to gleaning the importance of his words.

First, let's look at who Bernanke is: Dr. Ben Bernanke, prior to his recent appointment as a Federal Reserve Governor, was the Chairman of the Department of Economics at Princeton. He was the Director of the Monetary Economics Program of the NBER (National Bureau of Economic Research) and the editor of the American Economic Review. He co-authored a widely used textbook on macroeconomics. He is obviously well-respected in economic circles, and will be one of the more influential governors.

I believe this is his first major speech as a Fed governor. It was made to the Economist Club in Washington, which is not a small venue. Dennis Gartman referred to this speech as "... in our opinion the most important speech on Federal Reserve and monetary policy since the explanation emanating from the Plaza Accord a decade and a half ago."

We will look at the particulars in a few paragraphs, but we need to keep in mind this is not a random speech. While Bernanke states that the views in this speech are his own, for reasons I will go into later, I believe this speech is indicative of the thinking of various members of the Fed, and was given to make unambiguous the Fed's views on deflation. The title of the speech is very straightforward: Deflation: Making Sure "It" Doesn't Happen Here.

First and foremost, as Gartman wrote, "Dr. Bernanke has made it clear that the Federal Reserve Governors are painfully aware of the very severe problem that a pervasive deflation would manifest upon the US economy and the US society, and they are not prepared to allow that to happen. They will do what they must in order to alleviate deflation, including erring openly upon the side of inflation..."

On one level, this speech breaks no new ground from that of the previous Federal Reserve white paper on the causes of deflation in Japan, and what the US Fed and other central banks could do to avoid deflation. I wrote about that paper several months ago, stating that it was clear to me, at least, that the Fed understood the nature of the problem and was telling us they did not intend to see the US slip into deflation. This is one reason I believe the speech is reflective of Fed thinking, and not simply Bernanke's thoughts.

A Very Clear Fed Speech

The difference between that paper and Bernanke's speech is two-fold. The paper was presented in the framework of an academic exercise, and had no official stamp of Fed governor approval. It could be viewed as theoretical, although I and a number of other analysts did not see it that way.

Secondly, this speech was actually delivered in very clear, well written English. The average layman could read and follow the thoughts. Bernanke thus disqualifies himself for the role of Fed Chairman when Greenspan finally steps down, as it seems a requirement for the job of Chairman is the ability to talk at length and say very little that can be taken clearly.

You can read the speech at: http://www.federalreserve.gov/BoardDocs/speeches/2002/20021121/default.htm

First, let's go to the more controversial parts of the speech. What are they (the Fed) willing to do to avoid deflation? This is the part that has raised the hackles of more than a few writers. I will quote:

"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 to point out that the Fed could also supply interest free loans to banks, monetize foreign assets, buy government agency bonds, private corporate assets or any number of things that could induce inflation.

Those words, taken out of context, could be seen as rather extreme, confirming the worst fears about central banks among certain groups and yet another reason to buy gold. There may be reasons in this speech to want to add a little gold to your portfolio, but these sentences are not among them.

Let's look at what Bernanke really said. First, he begins by telling us that he believes the likelihood of deflation is remote. But, since it did happen in Japan, and seems to be the cause of the current Japanese problems, we cannot dismiss the possibility outright. Therefore, we need to see what policies can be brought to bear upon the problem.

He then goes on to say that the most important thing is to prevent deflation before it happens. He says that a central bank should allow for some "cushion" and should not target zero inflation, and speculates that this is over 1%. Typically, central banks target inflation of 1-3%, although this means that in normal times inflation is more likely to rise above the acceptable target than fall below zero in poor times.

Central banks can usually influence this by raising and lowering interest rates. But what if the Feds fund rates falls to zero? Not to worry, there are still policy levers that can be pulled. Quoting Bernanke:

"So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.....

"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). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

"Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. "

He then proceeds to outline what could be done if the economy falls into outright deflation and uses the examples, and others, cited above. It seems clear to me from the context that he is making an academic list of potential policies the Fed could pursue if outright deflation became a reality. He was not suggesting they be used, nor do I believe he thinks we will ever get to the place where they would be contemplated. He was simply pointing out the Fed can fight deflation if it wants to.

With the above as background, now we can begin to look at what I believe is the true import of the speech. Read these sentences, noting my bold, underlined words.:

"...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."

"The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending... "

Again: "...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 ."

"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys."

Now let us go to his conclusion: "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 our economy's underlying strengths but also 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. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, 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."

Stimulating Demand

Let's forget for the moment the debate about whether Fed policy can actually stimulate demand at all times and places. The quotes above demonstrate that Bernanke and the Fed board believes that is does. Beliefs will translate themselves into action. The Fed, when faced with slowing demand and deflation, will act in very predictable ways based upon their beliefs. They will work to stimulate demand.

Last week, I wrote about the speech by former Fed Vice-chairman Wayne Angell. He is still quite close with Greenspan. Angell spoke to the National Public Pension fund Forum. In summary, he said, "Deflation is bad. The Fed gets it. There are still things the Fed can do to prevent deflation and they will do what it takes."

Bernanke is a Keynesian. Angell is basically a monetarist. (These are schools of economic thought with differing views of how Fed policy works.)

Even with their differences, they both viscerally believe in the ability of the Fed to stimulate demand and prevent deflation. That is the lesson you need to take away from the Bernanke speech.

I have no quarrel with the view that a central bank can prevent deflation. As Bernanke noted, there are ways to create inflation. (He also correctly noted that there could be unknown consequences to many of the actions he discussed, as there is no practical experience with them in modern times.)

I also have no quarrel with the view that the Fed should work to prevent deflation.

However, I am not persuaded that in all circumstances that the Fed can stimulate aggregate demand with simple interest rate policies. And as I have noted before, I am not certain that the price of preventing deflation will not be stagflation, or worse.

In a typical business cycle, if the economy gets "overheated" and inflation starts to rise, a central bank can raise interest rates and tighten the money supply, thus slowing business growth and profits and lowering demand and therefore price inflation. If the economy gets into recession, a dose of low rates and easy money is the prescription. "Don't fight the Fed" is a rule we have been taught. It was a good rule to follow, until the 2001, when there has been a disconnect between the markets and fed policy.

My concern is that we are not in a typical business cycle. Just as a number of different economic factors all came together to cause the boom and then bubble of the 80's and 90's (disinflation, lower interest rates, lower taxes, lower international tariffs, the demographics of the Boomer Generation, stability, etc.), I think there are now forces at work which may not respond to the Federal Reserves levers. But that does not mean the Fed will not pull them.

For Bernanke, "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."

The deflation that is threatening today will not come as a result of a drop in aggregate demand, but as a result of excess production capacity and the rising influence of China and other markets where cheap labor is driving down production costs. It is acerbated by the continued competitive currency devaluation upon the part of many of the trade partners of the US. This is a tide of deflation that is sweeping the world. It is a global phenomenon, and not isolated to just one economy.

My concern is that the United States, in isolation, cannot prevent global deflation from coming to our shores without help from the rest of the world. And to date, we are not getting any help at all.

The Fed is between a rock and a hard place. If they allow deflation, it could very well bring on a case of Japanese Disease: a deflationary recession which is hard to get out of without serious consequences. Bernanke listed what could be done to get out of deflation should we find ourselves in it. He also noted that there could be unintended consequences of these actions. It is not something he, or anyone at the Fed, seriously wants to contemplate doing. Therefore, they will not allow deflation to actually develop if at all possible.

But how will the Fed prevent deflation?

If they create inflation by expanding the money supply at too high a rate, it will cause interest rates to rise, thus slowing the economy. The growth in US consumer spending starts to weaken as debt mounts and people start worrying more about repaying their debts and less about buying something new. If mortgage rates do not drop further, the amount of money available from refinancing mortgages drops. Most people are "cash flow" oriented. They have a budget for their monthly expenditures. If lower mortgage rates allow them to drop the monthly cost of the payment and pull out cash at the same time, then they take the extra cash. Conversely, higher mortgage rates mean higher monthly payments if they refinance to take out cash.

A retrenchment by consumers will put us into a recession. Fed Policy Lever: lower long term rates (thus mortgage rates) and stimulate aggregate demand.

Bernanke tells us they still have levers to pull if we face deflation. He also believes that the best way to combat deflation is to stimulate aggregate demand. To me, his speech indicates that means they will do what they can to lower long term rates and thus mortgage rates, as this is the clearest way to stimulate demand.

(As an academic note, the Fed fixed long term rates in the 1940's at 2.5% and 90 day rates were 0.375%. In the 1960's, during the Kennedy Administration, the Fed initiated something called Operation Twist which attempted to drive down long term rates.)

I do believe that lower interest rates stimulate demand. I think the reason we have not yet had a serious recession given the huge debt problems we have, the bursting of the stock market bubble and the global tide of deflation is partially due to the aggressive Federal Reserve rate cuts. These cuts have made mortgages cheaper, buoyed the housing market, help stimulate consumer spending, and made the cost of financing cheaper for US business, thus offsetting some of the negative effects of slower growth.

But between now and the next recession (and there will be a next recession, there always is) I don't see today where the forces of economic growth will come from that will allow the Fed to raise rates so that they will have more bullets in their recession fighting interest rate gun. Raising rates now will kill the US economy by reducing consumer demand and guarantee deflation. Therefore, this will not be done.

Therefore, we will enter the next recession with five or fewer 25 basis point bullets between current rates and zero. But the Fed believes that in the face of a recession they must act to stimulate demand. The policy lever at that point is to work to lower long term rates. This will not be something they want to do, but will be done when they think they have no other choice.

Let me summarize: We are in a Muddle Through Economy. The Fed will not be able to raise rates without throwing us into recession. Therefore, they won't. When the next recession rears its head, it is likely to have deflation written all over it. The members of the Fed viscerally believe that it is their duty to stimulate demand to avoid deflation, and they have the tools to do so. They will lower long term rates.

Why do this? Because from their point of view it is the right thing to do. They believe (with some justification, I might add) that the recent rapid round of rate cuts help avoid a serious recession. Housing and consumer spending held up due to the stimulus they provided. Business investment collapsed due to the excess capacity built up during the 90's. The ability of corporations to raise prices to increase profits was taken away.

The hope is that if they can keep the economy moving along, even slowly, that excess capacity will eventually go away and that US businesses will regain their ability to raise prices. The longer they can postpone the next recession, even by excess stimulation, the more likely it is that businesses will be in better shape. Hopefully, personal debt will start to decrease as well, and we can slowly over the next few years grow ourselves out of the current problems.

The belief (or hope) at the Fed is that we can work through the hangover of the 90's (debt, deflation, excess capacity, dollar bubbles, trade deficits, etc.) before they run out of interest rate/demand increasing bullets.

Rather than one very big recession which hits the reset button on the above problems, they hope to slowly deal with them one by one by growing our way out of the problems, stimulating demand every time we slip nearer to deflation and/or recession.

Can I fault this policy? No, as a big recession would produce a great deal of human misery, and not just in the US but worldwide. It might be a few millions jobs in the US, but it is life and death in many parts of the world which depend upon the cash flows from world trade for their very survival.

Pushing on a String?

Will it work? I hope so, but there are a lot of economic problems from then90's to deal with. There is a very real concern upon my part that because of global deflation the Fed is pushing on a string with its normal policies, and that ultimately the cure for deflation will cause discomfort. The best thing the Fed has going for it is that the US economy and US consumers have always surprised on the upside. If this was Europe, I would say, "Stick a fork in it. It's done." We will have to wait and see, but meanwhile we muddle through.

Long Term Rates Are Headed Down

Finally, I think this means that long term interest rates on government bonds will go down even more. It will not be smooth, it could even be more volatile than it has been in the past, but I think the long term direction is as clear. It will also probably take years for this to all play out. This is not a 2003 and it's over process. As I said almost two years ago, Greenspan has raised rates for the last time in his career. The question is how many more times will he lower them.

I will stop here, as I could (and probably should in the future) comment upon what Bernanke said about dollar policy. But it is time to go eat turkey.

The Pleasures of Life

A few years ago, someone challenged me to sit down and list the things that give me pleasure. I sat down and made a list which ended up almost five pages long. At the end of the process I was one very happy man, having thought for several hours about what gave me pleasure in life, both great and small. From things as mundane as a large, vine-ripe Big Boy tomato or a crisp Chardonnay, to the essential element of the love of my family, making the list was one of the most enjoyable things I have ever done, and going back and reading it from time to time reminds me the important things in life, which effect me personally far more than Fed policy.

I would suggest this holiday season that you consider making your own list, and share it with a few close friends. You will all be happier for it.

I have not had anyone proof this week's letter, so I hope there are not too many mistakes. And now, I am off to the kitchen to make that traditional Thanksgiving staple: mushrooms. I am not certain as to how good an economist or writer I am, but I am at the top of my game when it comes to cooking mushrooms.

I trust you enjoyed your weekend.

Your looking forward to the next few days with his family analyst,

Scroll down for comments.