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Fed needs firepower to zap deflation monster
By James Mackintosh
Published: August 13 2010 20:17 | Last updated: August 13 2010 20:17
http://www.ft.com/cms/s/0/fbb74668-a70b-11df-90e5-00144feabdc0.html


Every action film script has the hero running out of bullets at a crucial moment and reaching for whatever weapon comes to hand. Ben Bernanke may not have the pecs of Jean-Claude Van Damme, but the Federal Reserve chairman signalled this week he was willing to bash away with a baseball bat if that is what it takes to keep the economy going.

The US central bank has already cast aside its main weapon, interest rates, having slashed it to zero in the wake of Lehman Brothers’ collapse. On Tuesday, it reloaded its backup, quantitative easing – think Sigourney Weaver switching from pulse rifle to flamethrower in Aliens.

Unfortunately, the markets took the wrong message. Rather than being reassured that the deflation monster had a fight on its hands, investors decided to flee. Bad news on the economy in the US and China and renewed worries about the eurozone’s troubled periphery and European banks made matters worse. The nascent summer rally in equities came to a painful end, bonds rose and market inflation expectations tumbled.

Which raises the vital question: is the Fed firing blanks? Certainly, inflation is now expected to be lower – the Treasury futures market measure of implied inflation had its biggest one-day fall since the height of the Greek crisis. In Germany, bond markets are pricing average inflation of 0.78 per cent over the next five years, the lowest since the depths of the crisis last March. In the US, inflation is expected to average 1.67 per cent over the next 10 years, the lowest since September. Yet, investors still have faith in the ability of the authorities to prevent deflation. The belief is that printing money to buy assets such as Treasury bonds – quantitative easing – is bound to lead to inflation eventually, which is why the bond markets are not pricing in deflation. It is true that at some point printing money creates inflation, since each dollar, pound or euro is worth less in real goods. But extreme use of the printing presses undermines confidence in the currency and disrupts further an already distorted economy.

If I sound sceptical, it is not just because my British accent would automatically cast me as a villain in Hollywood. The Fed has already pumped more money into its quantitative easing than Japan, home of the deflation monster, has in the past 20 years. The result? The US has one of the weakest recoveries ever and deflation is still a risk. Of course, had it done nothing, we would probably be in depression.

What is certain is that unconventional monetary tools are back on the table, and not just in the US. For bond, equity and currency investors, this is a vital consideration. Switzerland remains on the cusp of deflation, in spite of the Swiss National Bank’s massive minting of new francs to buy euros, which saw it record embarrassing losses this year. Even the hawkish European Central Bank is rumoured to be intervening again, supposedly buying Irish government bonds.

The problem is that central banks alone cannot replace the banking system, and bank lending is barely recovering. Indeed, broad money is still shrinking in the US (see chart), as the private sector pays down debt, and is anaemic, to say the least, in the eurozone.

The risk is that helicopter drops of money into the economy from central banks simply lead to more debt reduction and hoarding. To address this, some economists suggest the most extreme measure yet: negative interest rates. This has been tried before, to address a different problem: Switzerland had a nominal -40 per cent rate for foreign deposits in the 1970s to try to avoid capital inflows (that failed).

But if banks faced negative nominal rates for money on deposit at the central bank – now near record levels – that should far more effectively encourage them to lend than exhortations from politicians. This would only be a small step, as rates could go no lower than about -0.25 per cent before it would be worth storing banknotes by the tonne (Willem Buiter, chief economist at Citigroup, has suggested abolishing physical money to solve this problem). There is a precedent. Sweden had a negative rate on excess reserves last year, although it did little since the Swedish banks were functioning normally.

There is one big disadvantage to a negative rate: it would amount to a tax on banks, since the overall level of central bank deposits must remain about the same – like the game of Old Maid, each bank would be trying to pass on the money. Charles Goodhart, an ex-member of the Bank of England’s monetary policy committee, points out that if banks were lending, negative rates would not be needed; they only have themselves to blame.

At the very least, this would hand Mr Bernanke a new weapon. Only by experimenting will we find out if it has the firepower to break deflation.