Last week, Mr. James Bullard was being both cagey and clairvoyant. The president of the St. Louis Federal Reserve Bank noticed what everyone else has seen for months; the US economic recovery is a flop. GDP growth was last measured pottering along at a 2.4% rate in the second quarter, less than half the speed of the last quarter of ’09. At this stage in the typical post-war recovery, GDP growth should be over 5% with strong employment. Instead, the “Help Wanted” pages are largely empty. Homeowners are still underwater. And shoppers are still largely missing from the malls that once knew them. Whatever is going on, it is not the “V” shaped recovery that economists had expected. Many now worry that the recovery might have a “W” shape – a “double dip recession” form, with GDP growth dropping down below zero in this quarter or the next.
Mr. Bullard told a telephone press conference he worries that the US economy may become “enmeshed in a Japanese-style deflationary outcome within the next several years.” That is exactly what is likely to happen.
But it is a little early for the Fed economists to throw in the towel. They still have some fight left in them. If they were really on the ropes, for example, they could throw their “widow maker” punch – dropping dollar bills from helicopters. This would make sure that the money supply increases, even if the normal distribution channel – bank lending – is broken.
In a celebrated speech on Nov. 21, 202, Mr. Ben Bernanke, then a recent addition to the Federal Reserve Bank’s board of governors, explained why deflation was not a problem:
Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost.
It was that technology to which Mr. Bullard referred when he ceased being prescient and began being cagey. He was not advocating dropping money from helicopters, not just yet. He was hoping he wouldn’t have to. Instead, he was raising the menace of inflation, in the hopes that that would be enough.
“By increasing the number of US dollars in circulation, or even by credibly threatening to do so,” Mr. Bernanke had continued, “the US government can also reduce the value of a US dollar in terms of goods and services, which is equivalent to raising 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.”
There’s the problem right there. The threat must be credible. Ben Bernanke’s speech title left no doubt about his intentions: “Deflation: Making sure it doesn’t happen here.” Back then, the reported consumer price measure stood at 1.7% – slightly below the 2% target. Perhaps it was that 0.3% undershoot that set Ben Bernanke to thinking about it. If so, we wonder what he must think now. Today, the Fed is off-target by 75%, which is to say, the measured inflation rate is just 0.5%. It is beginning to look as though Ben Bernanke’s reputation as a deflation fighter is more boast than reality.
The Fed’s Open Market Committee meets on August 10th. On the agenda will be more direct purchases of US Treasury debt – bought with money that didn’t exist previously. This is what economists call “quantitative easing.” It is a way of increasing the money supply. But quantitative easing is not the same as dropping money from helicopters. If you drop money from helicopters there is no room for ambiguity, and no doubt about what happens next. In a matter of seconds, your currency will be sold off, your loans called, and your credibility ruined for at least a generation. Quantitative easing, on the other hand, is a much more subtle proposition. It allows the central banker to maintain his credibility, at least for a while, because it doesn’t necessarily or immediately work. When the private sector is hunkering down, the money doesn’t go far. Prices don’t rise. Japan has done plenty of quantitative easing, with no loss to the value of the yen or to the credibility of its central bank. Europe has done it too. And so has America. The US Fed bought $1.25 trillion worth of Wall Street’s castaway credits in the ’08-’09 rescue effort. But instead of losing faith in America’s central bank, investors bend their knees and bow their heads. Incredibly, the US now announces the heaviest borrowing in history while it enjoys some of the lowest interest rates in 55 years.
A threat to undermine the currency, we conclude, is only credible when it is made by someone who has already lost his credibility. That is, someone with nothing more to lose. Bernanke, Bullard, et al, are not there yet.
for Markets and Money