Was it really just a few months ago that central banks were warning against the possibility of inflation  Ã¢â‚¬â€œ even stagflation  Ã¢â‚¬â€œ creeping into the economy? The Bank of England  and the European Central Bank  were so worried about inflation that they both raised or maintained their interest rates throughout the summer vowing to head off any surge in inflation.
But how quickly things can change. Within just a few months, the subprime-fuelled credit crunch tore through the international banking system, taking out several big-name firms along the way and spreading panic amongst investors. Oil prices Ã¢â‚¬â€œ which had played a large part in pushing inflation skywards Ã¢â‚¬â€œ retreated from a high of $147 a barrel in July to now hover around the $50 mark.
Suddenly, inflation was no longer a concern Ã¢â‚¬â€œ indeed talk of any economic growth was soon replaced with recession warnings and by mid-November, the European Union announced that it had Ã¢â‚¬Å“officiallyÃ¢â‚¬Â entered into a recession with the UK and the US expected to soon announce similar warnings. Good bye inflation Ã¢â‚¬â€œ hello recession.
Recession or Deflation?
With inflation out of the picture, the current debate now centers on whether we are entering a global recession Ã¢â‚¬â€œ defined as two consecutive quarters of negative growth Ã¢â‚¬â€œ or whether we are headed for a full-on bout of deflation. Deflation is loosely-defined as a prolonged period of negative growth and we have experienced episodes of deflation in the past century, but the classic example still remains the Ã¢â‚¬Å“greatÃ¢â‚¬Â depression of the 1930s. While a recession is bad enough, deflation gives governments and central banks nightmares because once it takes root, deflation can actually feed itself making it very difficult to break once established.
It happens this way Ã¢â‚¬â€œ as the economy slows, manufacturers and producers are faced with a reduced demand for their products and they react by cutting output and laying-off workers. For those who have lost their jobs, the immediate reaction is to reduce overall spending Ã¢â‚¬â€œ likewise, those who are still working tend to become more fearful about their own employment and the natural reaction is to reduce spending in order to boost savings in case they too become unemployed. In either case, the result is less overall spending which further reduces demand for manufactured goods leading to even more cutbacks in production and even more unemployment. This is known as a deflationary spiral.
The Bernanke Deflation Checklist Ã¢â‚¬â€œ How to Avoid Deflation
In 2002 Ã¢â‚¬â€œ shortly after leaving his position as Chairman of PrincetonÃ¢â‚¬â„¢s economics department to join the Federal Reserve  Ã¢â‚¬â€œ Ben Bernanke  gave a speech to the National EconomistÃ¢â‚¬â„¢s Club in Washington titled Ã¢â‚¬Å“Deflation: Making Sure Ã¢â‚¬ËœItÃ¢â‚¬â„¢ DoesnÃ¢â‚¬â„¢t Happen HereÃ¢â‚¬Â. In this speech, Bernanke stressed the Ã¢â‚¬Å“use of monetary and fiscal policy as needed to support aggregate spendingÃ¢â‚¬Â as the primary objective to avoid deflation; he summarized these tools into two main points keying on interest rates and economic stability through a well-capitalized banking system.
Aggressive Interest Rates Cuts
In this speech, Bernanke noted that Ã¢â‚¬Å“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 ratesÃ¢â‚¬Â. It looks like we can already check this one off the list Ã¢â‚¬â€œ at the beginning of December, 2007, the benchmark lending rate in the US was 5.0 percent but as the credit crisis deepened, the Fed slashed rates down to the current level of 1.0 percent. The problem now of course, is that when you are already this low, how much of an effect can another half a percent really have?
Well-Capitalized Banking System
With regards to economic stability, Bernanke states that the Fed must take Ã¢â‚¬Å“responsibilityÃ¢â‚¬Â to ensure a Ã¢â‚¬Å“healthy, well capitalized banking system and smoothly functioning capital marketsÃ¢â‚¬Â as an Ã¢â‚¬Å“important line of defense against deflationary shocksÃ¢â‚¬Â.
This one just jumps off the page as it was the lack of a Ã¢â‚¬Å“well-capitalized banking systemÃ¢â‚¬Â brought on by the subprime mortgage problems that forced the Fed Ã¢â‚¬â€œ and now the Treasury Department Ã¢â‚¬â€œ to provide liquidity to a banking system so terrified of toxic mortgage-backed assets, the banks refused to lend each other money. Way back in December of last year, as the full weight of the subprime crisis became clearer, the Fed created the Term Auction Facility (TAF) to provide funds to desperate banks.
Since the first auction on December 17th, 2007, the TAF has provided nearly $2 trillion in loans and this is in addition to the $700 billion Henry Paulson and the Treasury Department have more recently committed. So if all this money has already been put into play and we are still talking about the possibility of a recession or worse, just how much will it take to avoid further retracement and is the Fed willing to continue following this path?
According to Bernanke, Ã¢â‚¬Å“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 the 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.Ã¢â‚¬Â
You can draw your own conclusions from these comments, but my take on this is that Bernanke is more-than-prepared to continue to make money available to the financial system for as long as the Fed feels necessary. This will likely lead to further weakening of the dollar but with nothing to be gained from cutting interest rates, this really is the only option available.
About the Author
Scott Boyd has been working in and writing about the financial industry since the early 1990s. As a technical writer and project manager with several of Canada’s leading financial institutions, Scott has produced educational materials for investment system end-users including portfolio managers and traders. Scott now administers and contributes to OANDA FXPedia and regularly provides commentaries for the OANDA FXTrade website.