High is the New Low


It’s not QE2 exactly … QE-Lite maybe?  Whatever the case, the Federal Reserve made it official today that its board has decided (almost unanimously, as usual) to begin a new regime of “Quantitative Easing” (formerly known as “money printing”) and purchase some 340 billion in U.S. government debt*. The Fed assures us that its strong commitment to financing the government will make us all wealthy, productive, and happy.

Behind the scenes, there’s evidence that the Fed’s board has recognized that it has entered a kind of monetary Bizarro World in which most of what it once took for granted has been turned upside down. (Situations like this usually don’t end well.)

Exhibit A is the Fed’s Zero Interest Rate Policy (ZIRP). The Fed, of course, sets the “overnight” interest rate at which its member banks lend to one another; this has been one of its chief means of indirectly “managing” the U.S. money supply. Fed logic would tell us that if banks earn nothing by lending to their peers via the Fed, then they’d be incentivized to lend to businesses and individuals. ZIRP should “goose” the economy, expand credit and capital investment, and ultimately lead to higher prices.

The familiar Monetarist critique of ZIRP is that in putting interest rates at zero, the Fed had essentially blown its wad -- rates can’t get any lower, and thus the Fed can’t “stimulate” the economy any further if things ever get worse. Most Austrians, in turn, criticize ZIRP on the basis that it would create massive, uncontrollable credit inflation.

What has actually happened is quite different. The zero interest rate has instead revealed the great demand for liquidity and the striking absence of any desire to put cash out on loan. Simply, credit is cheap because no one wants to get involved with it: banks are sitting on reserves and corporations and individuals are deleveraging.  Low interest rates haven’t been coupled with an overheated economy but an extended period of credit deflation. Go figure.

As Eric King and Jim Rickards have discussed in a recent podcast, the mover and shaker of the moment on the Fed board, James Bullard, has picked up on this reversal and is now speculating that a higher overnight rate is the new way to induce banks to lend.

His theory, laid out in a recent paper, is that ZIRP indicates to banks that the Fed expects a protracted period of “deflation.” (A high rate of inflation must be matched by higher interest rates; if it weren’t so, then lenders would lose by loaning their money to creditors. A zero rate means no inflation.) In the new Fed logic, the central bank should jack up rates to indicate to its members that it expects inflation in the future, thus inducing them to worry that their reserves of cash would lose value if they weren’t put to work.

High is the new low.

What has stayed constant throughout this surprising turnabout is the money printing. Indeed, Fed chairmen and board members seem to be engaged in a long-standing battle of one-upmanship on this front. In a 2002 speech -- the one in which Bernanke expressed his willingness to, metaphorically, throw money at Americans out of helicopters -- the prospective chairman announced, “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the 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.

This speech was entitled “Deflation: Making Sure ‘It; Doesn't Happen Here.” Well, “it” most definitely happened. Despite Bernake’s doubling of the Fed’s balance sheet, over the past two years, credit contraction and deleveraging have overwhelmed money printing. Prices of assets, goods, and commodities fell.

Bullard’s answer is to be even bolder than the great “Helicopter.” Businesses and banks must be made certain that the Fed will do, in his words, “whatever it takes” to ensure that prices never go down. QE3, 4, 5, 6… What’s important is that money loses value and banks are forced to lend.

We should take him at his word.


* -- The Fed’s balance sheet will apparently be unchanged, as it will buy treasuries with the revenues from other assets.