The Fed Notices Deflation
Jude Wanniski
November 25, 2002


How nice. In a speech Friday, the new Federal Reserve Gov. Ben Bernanke  picked up on the references Chairman Alan Greenspan made to a possible “deflation” problem in recent talks. Six years into the start of the deflation in November 1996, the Fed has finally noticed something funny going on out there. Bernanke still does not understand the problem and is reaching into the obsolete textbooks for remedies, but we have to start somewhere and the ideas that have at least broken the ice will almost certainly lead in the general direction of correct remedies.

An academic Keynesian out of Princeton, Bernanke assured the markets that the central bank has plenty of additional tools to combat deflation if the federal funds rate, now 1.25%, gets close to zero and there is still no response from the economy. The various schemes he suggests for the most part involve adding gobs of liquidity to the banking system through the Fed’s purchase of bonds in the open market, either from the banking system or directly from a Treasury now facing deficits as far as the eye can see. Bernanke even goes so far as to suggest the administration could cut taxes to spur aggregate demand, and the Fed could buy the Treasury bonds to finance the cuts. He cites the Keynesian textbook example of the so-called “Treasury/Fed Accord” of 1942-51, which supposedly provided a mechanism for Fed purchases of Treasury bonds in order to keep the 20-year bond from rising above 2.5%.

Alas, we get back to Robert Mundell’s warning going back at least 35 years that the Fed can only hit one target with one instrument. If the Fed is targeting the funds rate at 1.25%.... or 0.025%, and then decides to add gobs of liquidity to buy bunches of long maturities, it will be forced to sell bonds to prevent the funds rate from falling below the target level. In other words, we cannot be on a “fed funds standard” and at the same time be on a “20-year-bond standard.” As fast as the Fed is buying bonds over here, it is forced to sell bonds over there. Lots of banks and other intermediaries make lots of money in the transaction process, but at the end of the day nothing has happened. At some point, after much debate and hand-wringing, the Fed board of governors will have to communicate to the Treasury Secretary that they will have to abandon the funds target if they are to be permitted to add more liquidity to the market than the market wants at the overnight rate.

This would be the flip side of what took us off the gold standard in 1971, when the Treasury was officially committed to the 1944 Bretton Woods system that promised foreign central banks it would redeem surplus dollars they had collected with gold, at $35 per ounce. In early 1971, President Nixon’s economists, conservative Keynesians, had advised adding gobs of liquidity to goose the economy and assure his re-election. But as fast as the Fed was buying bonds to add liquidity, they were coming back from abroad and the Treasury had to buy them back up. Finally, the phalanx of PhD economists persuaded Nixon to break the cycle by removing the Bretton Woods pledge to mop up unwanted liquidity. Rampant inflation was the result.

So you see, the steps being recommended now by Bernanke -- with the other Fed governors in seeming sympathy -- is practically a mirror-image step. At some point, sometime in the new year, we should expect a move of this kind. And when it does not work, “wisdom” will move the players to quietly recommend that the funds standard be abandoned so the “20-year bond standard” can go to work. When that happens, grab your socks, because we will be back on an inflation binge, unless someone at the center is able to stop the new bond-buying “solution” when gold hits its optimum level of $350 or so. It is in this vicinity that we might expect at least an opportunity for a “commodity standard,” as a way station to gold.

Parenthetically, it should be mentioned that the fabled “Treasury/Fed Accord” worked like a charm because the U.S. dollar was the only major currency during WWII that was still convertible to gold, at the aforementioned $35 per ounce. The rest of the world was not bringing in dollars to get gold, because dollars were scarce relative to gold in this wartime circumstance. Throughout the period, the rest of the world sent gold to the U.S. Treasury! The Fed had to add liquidity to prevent the price of gold from going lower and bringing in even more bullion to Fort Knox! By the end of WWII, two thirds of all the gold bullion in the world was in Fort Knox or in the vaults of the New York Fed. If I remember correctly, there was $30 billion gold in the world and the U.S. had $20 billion. It may take another two or three decades for the economics textbooks to understand how this worked.

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We still have Iraq hovering over Wall Street and the world economy and things are actually going well, but in this case we face “the threat of peace” on the deflation front. See Bob Novak`s column today on the President`s state of mind. The fact the President has the rest of the world solidly behind him on Iraq is because he gave in to the rest of the world on the United Nations as the policing vehicle. As the “threat of peace” becomes clearer, the price of gold declines and so does the price of oil. With a few notable exceptions, the national press corps still thinks the U.S. will be at war in two or three months, but that will have to mean Iraq screws up in some way. Once we get by the December 8 deadline, when Iraq is required to submit a pile of paperwork all about its weapons of mass destruction, the inspection process will extend for several months, and the political world will get used to the idea that the inspectors are not going to find anything. We can expect Iraq to deliver a mountain of paper to meet the deadline, inviting the UNMOVIC inspectors to look through it for something it might consider suspicious. From every angle, it seems highly unlikely anything will be discovered that constitutes a smoking gun – or Saddam would not be so happy to have them prowling around instead of bombing.

What remains is an extremely poor fiscal condition at all levels of government. Forget the hundreds of billions projected for the few years ahead. The unfunded liabilities of the government entitlement programs are at $60 trillion and counting. Neither political party is interested in talking about that problem these days. It’s a problem that can be solved, but not with any of the ideas that are being discussed at the moment in Washington. A prerequisite is a gold/dollar link, and we are at least thankful conventional wisdom is beginning to turn in that direction with the Bernanke breakthrough. Wall Street has almost certainly seen its worst days, although better days are still over the horizon.