Missing Bernanke and Playing Powerball

Greece has me worn out. That being said, everyone even tangentially attached to the financial markets needs to understand what is on the line over roughly the next two weeks. If you want to abandon the dissertation research and read one outstanding, comprehensible and at times funny piece on the state of the Greece saga, go to The Eurozone: Collateral Damage by John Mauldin. 

Perhaps obvious in retrospect: Employing the same charm and negotiating strategy of Daffy Duck (who I love, by the way - Robin Hood Daffy being one of the greatest cartoons of all time), while standing at the business end of the ECB's bazooka, is liable to get you a beak full of buckshot.

Not obvious to me: Analysts and economists have cited the risk of deflation in the Eurozone as one of the potential economic effects of a presumably chaotic Greek exit of the monetary union. Not being an economist (oh, you betcha) I had to refresh my memory on why a little deflation is such a bad thing, whereas a little inflation - FOMC target of 2.0% per year - is considered ideal. This led me back to a profoundly informative, and at times eerily prescient, speech by academic expert on deflation and former Fed Chairman Ben Bernanke.

The problem and risks of deflation. When Bernanke gave this speech in November 2002, the economy was suffering the repercussions of the tech bubble bursting, and the Fed and the economy was experiencing its first cycle where short term rates were close to zero. The fed funds target rate had been lowered from a peak of 6.50% in 2000 to 1.75% for most of 2002; it was eventually lowered to 1.00% in 2003 and held there, before a tightening cycle began in June 2004.

What follows are bullet points taken directly from Bernanke's November 21, 2002 speech, Deflation: Making Sure "It" Doesn't Happen Here. The text in this section is quoted directly from his speech, with occasional moderate paraphrasing, unless otherwise indicated as an editor's aside (edited for brevity, formatting added):

With inflation rates now quite low in the United States, some have expressed concern that we may soon face a new problem--the danger of deflation.

Deflation: Causes and Effects 

Deflation is defined as a general decline in prices. At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

Editor's aside: The above is a textbook description of the recent collapse in the price of oil. It provides insight into why the Fed is monitoring the oil sector weakness for possible transmission to the broader economy, but does not yet appear to be alarmed by the drop in the oil price alone.

 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 economic effects of a deflationary episode are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress. 

Preventing Deflation

The basic prescription for preventing deflation is straightforward in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation.

There are several measures that the Fed - or any central bank - can take to reduce the risk of falling into deflation.

(1) The Fed should try to preserve a buffer zone around the inflation rate, generally between 1 and 3 percent per year, which reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. 

(2) The Fed should take most seriously its responsibility to ensure financial stability in the economy. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks.

(3) As suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.

But suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed's policy instrument--the federal funds rate--were to fall to zero. What then?

Curing Deflation

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.

Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. 

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.

Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association). 

A complementary policy option to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. 

Editor's aside: Chapter and verse of how to ease monetary policy when interest rates are at the zero lower bound - six years ahead of the financial crisis. I really should have paid more attention in class.

Fiscal Policy

The effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities.

A broad-based tax cut accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices.

In lieu of tax cuts or increases in transfers, the government could increase spending on current goods and services or even acquire existing real or financial assets.

Editor's aside: not mentioned? Severe austerity as a fiscal policy to prevent or cure deflation. In fact, exactly the opposite. So if it's "so simple" to deal with deflation, how come Japan hasn't gotten out of the deflationary lost decade? Bernanke goes on to address this (because he is a god).

Japan

The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation?

Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies.

Second, and more importantly, the failure to end deflation in Japan  is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. Restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve. 

Editor's aside: Economists continue to warn that this could easily be the US in five years, when entitlement payments begin to bankrupt the government as the baby boom generation reaches full retirement. Our options are extremely limited given that the debt has exploded since 2002 given the dramatic increases in spending and decline in revenues brought on by the financial crisis and expansionary government policies.

Footnotes (because they can be the best part)

1. Conceivably, deflation could also be caused by a sudden, large expansion in aggregate supply arising, for example, from rapid gains in productivity and broadly declining costs. I don't know of any unambiguous example of a supply-side deflation, although China in recent years is a possible case. Note that a supply-side deflation would be associated with an economic boom rather than a recession.   

Not sure if this could also be considered what is going on in the energy sector with the supply increase due to shale oil and natural gas. Perhaps a good question for a deflation expert.

5. A rather different, but historically important, problem associated with the zero bound is the possibility that policymakers may mistakenly interpret the zero nominal interest rate as signaling conditions of "easy money." The Federal Reserve apparently made this error in the 1930s. In fact, when prices are falling, the real interest rate may be high and monetary policy tight, despite a nominal interest rate at or near zero.

6. Several studies have concluded that the measured rate of inflation overstates the "true" rate of inflation, because of several biases in standard price indexes that are difficult to eliminate in practice. The upward bias in the measurement of true inflation is another reason to aim for a measured inflation rate above zero.   

FYI: this is why many economists, government agencies and policymakers have been trying to get Congress to change the law so that retirement benefits, et al will be indexed to what is called "chained CPI" instead of "core CPI". Experts on both sides of the aisle have long known that CPI overstates actual experienced inflation, and that a modest recalculation would save money and better reflect reality. Unfortunately voters - energized by the lobbying of AARP - have refused to allow their benefits to be "cut" and politicians are wary of the backlash. 

11. An episode apparently less favorable to the view that the Fed can manipulate Treasury yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling at the short end and buying at the long end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.

Brian Sack didn't invent Twist?? Didn't work in the 1960s. Didn't work in the 2010s.

I'm going to stop there, but please read Bernanke's speech. Well worth the time and effort.

Powerball!

 The estimated jackpot is up to $450 million (payable in yearly installments over 29 years, or something like that). The upfront cash value is $304 million. The probability of winning on a single ticket is 1 in 175 million.

I didn't start playing powerball - e.g. contributing $20 to a group of tickets collected on the trading desk - until a colleague said to me "you know, if we win, none of us are coming to work tomorrow. And you'll feel pretty stupid sitting here on the desk by yourself."

He knows who he is, and he reads this blog. But I don't play until it gets to ~$200 million. Don't start with me. I have a PhD in probability and I can still be as irrational as the next person. Good luck and go team!