Stephen King: Bernanke's blueprint for dealing with the horrors of debt deflation

December 1, 2008

In late-2002, Ben Bernanke, now the chairman of the Federal Reserve, gave a speech entitled "Deflation: Making Sure 'It' Doesn't Happen Here". Then, Mr Bernanke was merely a Fed Governor and had yet to make his way to the very summit of the central banking profession. Nevertheless, there can be no doubt that the thoughts expressed in that speech are thoughts which, once again, are very relevant.

After the stock market crash in 2000, there was genuine concern that a Japan-style deflation was on its way in the US and, perhaps, in parts of Europe too. The Federal Reserve had cut interest rates aggressively.Indeed, by the summer of 2003, the key policy rate had dropped to just 1 per cent. This was a disturbing development to the extent that a central bank cannot easily reduce interest rates to a level below zero (cash, after all, has a zero interest rate by definition). Mr Bernanke, however, was keen to stress that "a central bank whose accustomed policy rate has been forced down to zero has more definitely not run out of ammunition."

Much of Mr Bernanke's speech was devoted to the "unconventional" options available to the Federal Reserve in this eventuality. For example, the Fed might announce a ceiling on the level of longer-term government interest rates and commit to buying government paper to ensure that the ceiling wasn't breached. Alternatively, the Fed could extend fixed-term loans to banks at low or zero interest rates. Mr Bernanke also talked about a money-financed tax cut which he described as "essentially equivalent to Milton Friedman's famous 'helicopter drop' of money" or, in more common parlance, the use of the printing press.

I referred to this option in last week's column and got plenty of abuse from some readers for doing so. However, as Mr Bernanke emphasised in his speech, there are situations where this option has to be considered, not because there is any intention to create inflation but, rather, because debt deflation is perhaps the most difficult economic challenge facing any policymaker.

Most of us have fortunately never had to experience such an outcome. For those who struggled to make a living in the US in the 1930s, though, it was a truly awful development. Millions upon millions of people lost their jobs and their homes, not because they had borrowed too much in the first place but because, as prices and wages fell, the real debt burden unexpectedly went up. The zero bound on interest rates can, when accompanied by falling prices and wages, force monetary conditions to become exponentially tighter: unconventional measures, including the printing press, attempt to deal with this problem.

While Mr Bernanke's speech focused on unconventional measures, he was also keen to stress that, with deflation, prevention was always better than cure. One problem with unconventional policies is that they've hardly ever been used. As a result, they're probably better in theory than in practice. Another problem is the exit strategy: it's all very well for the central bank to buy government bonds or, as is the case with the Fed currently, commercial paper, but when do you stop? And, if you do, what then happens? What sort of capital market are you left with if most of the assets are now owned by the taxpayer?

In 2002, Mr Bernanke was (rightly, as it turned out) confident that deflation would not take hold. His words, though, now sound uncomfortably prophetic. In one section of the speech, he said "a healthy, well-capitalised banking system and smoothly functioning capital markets are an important line of defence against deflationary shocks." Oh dear. The crisis we've seen over recent months suggests that, this time, deflation must be a far bigger risk than was the case back in 2002. Then, the US (and global) banking system appeared to be relatively healthy. Six years later, and the narrative has changed.

To see why, consider the two charts. The first shows the actual path for the Federal Reserve's policy rate – Fed funds – since the middle of last year. The chart also shows the way in which expectations for interest rate levels in December 2008 have changed over time, using both Fed funds and US 3 month interbank rates (the rates at which banks lend to each other).

Expectations have declined in line with policy actions, suggesting that markets fully understand the Fed's intentions. A gap, though, has opened up between expectations for Fed funds and 3-month interbank rates. Over time, then, markets have taken the view that the policy rate can no longer quite so easily control the interest rates that matter to you and me. There are lots of reasons why interbank rates have proved to be so sticky, but one important factor is a rise in counterparty risk: banks are reluctant to lend to each other, fearing yet more Lehman Brothers-type events.

The second chart shows the crisis to be not just about the price of credit. It comes from the Fed's Senior Loan Officer Survey, which simply asks each bank whether it has tightened or loosened lending conditions over the previous three months. A year or so ago, tightening signs were, unsurprisingly, focused mainly on real estate, either through cutbacks in mortgages or lower loans to real estate developers. Now, though, there's compelling evidence that corporate America is also being hit. For companies of all sizes, the credit crunch is a painful reality. Even if the price of credit is right, the quantity is sadly lacking.

All this has happened through a period when the Fed has been slashing interest rates and where, in the second quarter of this year, the Bush Administration delivered a range of tax rebates. This is scary stuff: the policy measures which in normal circumstances support an economy which finds itself in difficulty appear not to be working very well. Hopefully, it may all just be a question of lags: even in the best of times, changes in policy take a while to bring benefits to an economy. The more recent evidence, though, suggests that the transmission mechanism of conventional economic policy has broken down.

Mr Bernanke's 2002 speech is, therefore, hugely relevant. It shows what can be done when conventional policy weapons fail and, today, can be treated as a practical guide for the Fed's next steps. Last week, the Federal Reserve announced it would be buying mortgage-backed securities and asset-backed securities. It won't be long, I suspect, before the Fed is buying up corporate bonds, a suggestion made recently by, among others, Richard Cookson, the global head of asset allocation at HSBC. And, if all else fails, Mr Bernanke will be putting on his helmet and hopping into his helicopter. Debt deflation is the worst of all macroeconomic ills: we shouldn't estimate the resolve of the Federal Reserve to stop "It" in its tracks.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com [http://mailto:stephen.king@hsbcib.com]