Presents

Introduction.

This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind.

I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future.

I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed.

Background.

Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future.

The Federal Reserve Makes a Choice.

We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome.

To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward.

Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view).

Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:

• "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no."

Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:

As GB Eggertsson put it:

• "Keynes argued that increasing the money supply has no effect at low nominal interest rates. This has been coined as the liquidity trap."

If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke’s apology the first signpost on his intended path.

Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system.

However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced.

Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:

• "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ. To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years. Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility." Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)"

At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral.

Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction.

As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high.

The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future.

Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow).

Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

• The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation. At zero nominal interest rates higher inflation expectations reduce the real rate of return, and thereby raise aggregate demand and the price level. The two main assumptions underlying this result is that there is some cost of taxation which makes this policy credible and that (2) monetary and fiscal policies are coordinated.

Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures).

However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:

• "Deficit spending has exactly the same effect as the government following Friedman's famous suggestion to "drop money from helicopters" to increase inflation. At zero nominal interest rates money and bonds are perfect substitutes. They are one and the same: A government issued piece of paper that carries no interest but has nominal value. It does not matter, therefore, if the government drops money from helicopters or issues government bonds. Friedman's proposal thus increases the price level through the same mechanism as deficit spending. Dropping money from helicopters, however, does not increase prices in a Markov equilibrium because it increases the current money supply. It creates inflation by increasing government debt which is defined as the sum of money and bonds. In a Markov equilibrium, it is government debt that determines the price level in a liquidity trap because it determines expectations about future money supply."
  

Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:

• "The government, however, can increase its debt in several ways. Cutting taxes and dropping money from helicopters are only two examples. The government can also increase debt by printing money (or issuing nominal bonds) and buying private assets, such as stocks, or foreign exchange. Ina Markov equilibrium, these operations increase prices and output because they change the inflation incentive of the government by increasing government debt (money & bonds). Hence, when the short-term nominal interest rate is zero, open market operations in real assets and/or foreign exchange increase prices through the same mechanism as deficit spending in a Markov equilibrium."

As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk.

It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage.

Since 2000:

• The US Government has run an increasing deficit.
  

  The Fed has allowed the movement of interest rates to compliment a notionally low interest rate environment. The withdrawal of M3 increased inflationary expectations.

  The loosening of regulatory oversight allowed a wider use of debt and increased consumption.

Since mid 2007:

• The US Government has explicitly talked of increasing govt debt through tax rebates and targeting relief at overburdened indebted homeowners through the expanded use of Govt Sponsored Enterprises.
  

  The Fed cut interest rates aggressively below rates of inflation and introduced facilities to engender the outright purchase as well as the long and short term loans of cash and US Govt Bonds.

  The US Treasury does not rule out making the new Fed facilities permanent.

I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow).

The Future

We now turn our attention to the future. At this point we have to examine something previously mentioned in our article, a Markov equilibrium. Again from Eggertsson:

• I analyze equilibrium under two assumptions about policy formulation. Under the first assumption, which I call the commitment equilibrium, the government can commit to future policy in order to influence the equilibrium outcome by choosing future policy actions (at all different states of the world). Rational expectations require that these commitments are fulfilled in equilibrium. Under the second assumption, the government cannot commit to future policy. In this case the government maximizes social welfare under discretion in every period, disregarding any past policy actions, except insofar as they have affected the endogenous state of the economy at that date (defined more precisely below). Thus the government can only choose its current policy instruments, it cannot directly influence future government actions. This is what I call the Markov equilibrium.

Essentially policy is either forward looking and adaptive or it works only in the "here and now" and cannot innovate.

Clearly my reading of the current situation is that the Fed and US Govt is committed to a future policy in its actions and has displayed the ability to be adaptive. Therefore we shall take that path to find what future developments may await us.

Again we rely on Eggertsson to lay out the groundwork:

• "deflation can be modelled as a credibility problem if the government is unable to commit to future policy and it's only instrument is open market operations. This....illustrates how the result changes if the government can use fiscal policy as an additional policy instrument. I first explore if deficit spending increases demand. When the government coordinates fiscal and monetary policies it can commit to future inflation and low nominal interest rate by cutting taxes and issuing nominal debt. I then use the result to interpret the effect of open market operations in a large spectrum of private assets, such as foreign exchange or stocks."

It is without doubt the most forward looking statement I have seen. Or is it? Again we must look at this from behind Bernanke's desk to truly appreciate what we are reading. The statement is forward looking because it has been adopted as policy. We are living with these actions right now and we know that they will exist for at least 6 months as has been made clear in statements from the Fed. Expectations of a continuing inflationary bias must be deeply entrenched in the psyche of anyone connected to asset markets.

Eggertsson continues:

• "Friedman suggests that the government can always control the price level by increasing the money supply, even in a liquidity trap. According to Friedman's famous reductio ad absurdum argument, if the government wants to increase the price level it can simply "drop money from helicopters." Eventually this should increase the price level-liquidity trap or not. Bernanke (2000) revisits this proposal and suggests that Japanese government should make "money-financed transfers to domestic households-the real-life equivalent of that hoary thought experiment, the "helicopter drop" of newly printed money." This analysis supports Friedman and Bernanke's suggestions. The analysis suggests, however, that it is the increase in government liabilities (money & bonds), rather than the increase in the money supply that has this effect."
  

• "Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets).
  

• It is often suggested that the central bank can depreciate the exchange rate and stimulate spending by buying foreign exchange (and similar arguments are sometimes raised about some other private assets and their corresponding price). Due to the interest rate parity (and similar asset pricing equations for other private assets), however, buying foreign exchange should have no effect on the exchange rate unless it changes expectations about future policy (since the interest rate parity says that the exchange rate should depend on current and expected interest rate differentials).

• Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government.
  

If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas.

Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example.

The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise.

Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation.

A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth.

Is the path hyperinflationary?

To be blunt, no. These are anti deflationary measures that will give the Fed credibility in fending off the dreaded scenario. The threat to the policies is an acceptance of deflationary expectations by private money and consumers.

Hyperinflation would be unable to form as an expectation as long as the Fed continues to display a hawkish approach to inflation. As we have seen the delivery of fiscal debt, in the form of "helicopter drops" would bypass the pricing mechanism. Expectations of hyper-inflation would be negated.

Conclusion. Is it working?

It is at this stage that I can happily say that it would be unfair for me to judge whether the policy is working or not. This because the whole scenario, the playing out of the policy, is to do with perception. The only way that it can be measured by individuals when attempting to answer the question is to screen what they see through this article (or G B E's Fiscal Theory). As the writer if I answer the question I might colour an individual's perception.

What I can say is that with the framework exposed and on public view we have the advantage of spotting potential failure of policy. The potential for failure is increased by discussion and the recognition of the long term policy objectives (avoiding deflation) if such discussion raises the expectation of deflation.

I should remind readers that this article is my interpretation of G B Eggertssons' work. I believe it is the blueprint being used by the Fed and US Govt. Therefore I claim no superior knowledge to Eggertsson, just an understanding and the ability to navigate.

What should be remembered is the title of G B Eggertsson's paper:

The Deflation Bias and Committing to Being Irresponsible

In other words the future actions of the Fed and US Govt may appear "wrong" unless we understand what they truly fear.

This Letter is a follow on from my articleThe Future Actions of The Federal Reserve and US Govt are known in which, using the work of GB Eggertsson, we showed that the Fed/US Govt is following a plan to stimulate the economy and avoid a deflationary episode. Essentially the plan is to avoid the mistakes of the Depression and those of Japan in the 90's by using increased Government debt, monetized by the Fed, targeted directly at consumers. By employing a credible threat of an inflationary stance the Fed/US Govt hope to raise inflation expectations and therefore raise the price of assets.

Whilst the groundwork for such actions are already in place as discussed previously, I now wish to concentrate on the effects such actions will have in thefuture. Again, I have to write this article without recourse to;my own thoughts to keep an objective viewpoint. I will be using GB Eggertsson again as a reference point. Although it would appear to narrow the perspective the fact that his Theory is in play and he is a member of the New York Fed staff would lend weight to his other work in this regard. In December 2005 Eggertsson published a paper entitled "Great Expectations and the End of the Depression" in which he laid out how the policies of President FD Roosevelt allowed the economy to depart from a deflationary environment.

What I want to show is that Eggertsson has based his theory on the successful polices and methods employed by FDR and what effect those policies had on the economy. Within the paper Eggertsson lays out arguments that support the FDR policies as the only credible approach to economic stimulus during a period of deflation. I believe that those policies are now being used to circumvent the current threat of a deflationary period caused by the credit crash.

Before we begin, I would like to show you a quote from the time as FDR enacted his policy change, referred to as a "regime change" (Sargent 1983 and Temin & Wigmore 1990):  

• "It is hard to overstate how radical the regime change was. "This is the end of Western civilization,"  declared Lewis Douglas, Director of the Budget, for example.(2) During FDR’s first year in offi ce several senior government officials resigned in protest.(3)" 

• 2)Cited in Davis (1986), p.107. (3)These included Lewis Douglas. The acting Secretary of the Treasury, Dean Acheson, was forced to resign due to his oppisition to unbalanced budgets and the abolishment of the gold standard.
  

History

• "The effect of the FDR regime shift is clearly evident in the data. When FDR was inaugurated in March 1933 excessive deflation turned into modest inflation. There was little change in the trend growth of the monetary base around this turning point. Money growth did not start on a sustained upward trend until several months after prices started to rise. Similarly, the fiscal expansion happened with a substantial lag.
  

  This evidence suggests that the recovery was driven almost exclusively by expectations about future policy. The comparison between FDR’s first term in office (1933-37) and President Herbert Hoover’s last (1929-33) is striking. Hoover’s last term resulted in 26 percent deflation, while FDR’s first registered 13 percent inflation. Similarly, output declined by 30 percent from 1929-1933. This was the worst depression in US history. In contrast, 1933-1937 registered the strongest output growth (39 percent) of any four year period in the US history outside of war."

This would support the argument that the increase in debt raised inflation expectations, leading to an increase in monetary demand.

Form this we can infer, without reference to historical writings, that FDR was seen as credible in his regime change, it was this credible approach that allowed inflation expectations to be seen as correct and for monetary requirements to change accordingly.

The Effects

As FDR took office, there was a noticeable turnaround in expectations. Firstly, lets see what the baseline was, according to Eggertsson:

• "The reason for the collapse is that the central bank cannot lower interest rates enough to accommodate deflationary shocks, due to the zero bound on interest rates and is unable to change expectations about future policy. This creates a strong deflation bias. The deflation bias helps explain the severity of the Great Depression, because real interest rates were excessively high in 1929-33 due to double digit deflation. This choked spending, especially investment. "Money was king" during this period. Nobody was interested in investing when the returns from stuffing money under the mattress were 10-15 percent in real terms. People gained more, in other words, from holding money than spending it."
  

Or as I said, why spend today when it will be cheaper tomorrow? It is clear that to make the Eggertsson Theory work, the baseline conditions of the economy should be depressed before allowing the already prepared stimulus to be released. Compare the conditions in 1933 to those today:

• "The short-term nominal interest rate was close to zero during the Great Depression. The yield on three month Treasuries, for example, was only 0.05 percent in January 1933. Further interest rate reductions were clearly not feasible. Open market operations, in themselves, had no effect, since money and government bonds were perfect substitutes. This explains why several observers at the time were skeptical of the effectiveness of monetary policy and believed that open market operations were just like "pushing on a string".
  

  Despite this, however, monetary policy was far from powerless. While increasing the money supply at zero interest rate has no effect, expectations about higher future money supply (once deflationary pressures have subsided and interest rates are positive again) have large effects because they change people’s expectations about the future price level, thus reducing real interest rates. What was needed to end the Depression was a regime shift that changed expectations about future policy in a credible way. This is precisely what FDR achieved."    
  
  

With current 3 month yields at at 1.13% and inflation measures well above, it can be seen why the Fed/US Govt fear a deflationary scenario. The requirement for a credible policy that will result in rising inflation expectations is absolute, to ensure that neither the consumer or business is discouraged from spending or investing. (This has far-reaching consequences, for instance it would not be in the Fed interest to suppress the price of gold)

With this in mind, let us look at some of the effects that FDR policy regime change had post 1933:

Again, it is clear to see that the expectations of rising inflation based on a credible policy had an almost instant effect on assets and prices before fiscal and monetary policy had time to make their actual changes felt.

Comparisons to Today

This also backs up my assertion thatthe Fed/US Govt have been following Eggertsson's Theory for longer thanmost realise. Here are the same charts for today:

CRB Index - Commodities

S&P 500 - Stocks

It would appear that inflation expectations are building, despite the evident slowing of the economy (GDP). What is most noticeable is that current conditions are not comparable to the situation in 1932/33. Whilst there has been a fall in stocks and overall commodities, we have not seen a drop in CPI andcertainly not the deflationary contraction of the period.

Why then are the Fed/US Govt pursuing the current course? It is here we have to begin to realise that the Fed/US Govt are following a preventative course, rather than applying Eggertsson Theory as a recovery programme. With Ben Bernanke well versed in the Depression and Japan 90-current, it can be assumed he would act quickly to prevent the full effects of a credit based deflation from taking hold. It could be said he has "jumped the gun". As we saw in my previous article, this would be by appearance only, the Fed has been actively planning for a breakdown in credit markets for sometime. Current new policy innovation is the second stage of the plan, one that began back in 2001/2.

The reflation under Alan Greenspan has much more in common with 1933 than the current circumstance but started from a higher base. It could be seen that the use of innovative mortgage solutions and equity withdrawal from 2002 onwards is comparable with the cash/asset swap carried out by FDR with his gold purchase programme, a way of exchanging savings for a direct cash injection.

What we are seeing today is more akin to the recession in 1937/8. This becomes important as the causes of the '37/38 recession were not dissimilar to the reasons for thecurrent situation. Here again from Eggertsson:

"Another useful observation is that there was a short but severe recession in 1937-38, which resulted in a slowdown in growth in 1937 and an output contraction of 5 percent in 1938. If not for this contraction the economy could have fully recovered as early as 1938. In this case a full recovery from the worst depression in US history, which reduced output by a third, left a quarter of the population unemployed, and devastated the capital stock, would have taken only 5 years.

Explaining the slow recovery, therefore, is to a large extent to explain the recession in 1937-38. The most convincing explanation for the depression in 1937-38 is given by Friedman and Schwartz (1963). They argue that the Federal Reserve’s increase in reserve requirement of commercial banks in May 1937
was responsible for the contraction. Following this the economy went into tailspins of deflation and output losses. This explanation is often criticized on the grounds that banks were already holding large excess reserves so that imposing these requirement did not have any real effects (interest rates rose only
modestly in response). The model of this paper, however, supports Friedman and Schwartz’s hypothesis and to some extent strengthens it by taking the expectation channel into account. The increase had such a disastrous effect because it changed expectations from being inflationary to being deflationary. It was the expectation that the Federal Reserve would stand ready to stamp down any further inflation that caused the collapse in 1937-38 rather than the new reserve requirement itself.

Interestingly, the disastrous effect of this policy had already been predicted by market participants as early as 1935. S. Parker Gilbert, a partner in J.P Morgan & Company, warned the Federal Reserve in the New York Times in December 1935 that an increase in reserve requirements would strangle the recovery because it would be interpreted as if the Federal Reserve had reversed its inflationary policies.23 The recovery did not resume until 1938, when FDR forced the Federal Reserve to reverse its policy and the Treasury simultaneously  embarked on further fiscal expansion"

"Historical evidence indicate that the Treasury reacted strongly to this action precisely because it was inconsistent with the policy regime suggested above. Marriner Eccles, the governor of the Federal Reserve, described the reaction of the Secretary of Treasury, Henry Morgenthau, to the increase in interest rates in May 1937 which was due to an increase in reserve requirements (see Eccles (1951) p. 292).

"I was out of Washington when this happened. After hurrying back to do what I could to correct the situation, I found Secretary Morgenthau understandably disturbed about the fall in government bond prices [i.e. increase in short term interest rate]. He insisted that the Federal Reserve Board rescind its order for the second part of the [reserve requirement] increase, which was to go into effect on May 1. In a tense meeting at his home on Saturday night he let it be known that if the Board failed to do what he urged, he would release a substantial amount of sterilized gold and thereby create new reserves that could be used to bolster the government bond market."

What this quote illustrates is that the Secretary of the Treasury threatened to take monetary policy away from the Federal Reserve unless it kept interest rate low. As Eccles notes the action the Secretary threatened "would indicate that the Secretary of the Treasury had taken over control of monetary and credit policy" because a release of sterilized gold would have lead to a corresponding increase in the monetary base

This narrative evidence indicates that the Treasury wanted inflationary policies to protect the low interest rate it was paying on its outstanding debt, consistent with the policy regime....It would take some time for Secretary Morgenthau to cow the Federal Reserve into reversing its policy but it finally did so in 1938 by order ofFDR"

• "Under SFAS 157, it is appropriate for you to consider actual market prices, or observable
      inputs, even when the market is less liquid than historical market volumes, unless those
      prices are the result of a forced liquidation or distress sale. Only when actual market prices,
      or relevant observable inputs, are not available is it appropriate for you to use unobservable
      inputs which reflect your assumptions of what market participants would use in pricing the
      asset or liability."
   

Has the Fed/US Govt laid the groundwork for a critique of Basel 2? Indeed it has, in "Basel 2: The Roar That Moused" by George G Kaufman, written under the auspices of Loyola Univ Chicago and The Federal Reserve Bank of Chicago 2003.

• "This paper supports much of the criticism of proposed Basel II, particularly with respect to pillar 1. However, regardless of the complexity or desirability of RBC computed according to pillar 1, the provisions of pillars 2 and 3 are inadequate to enforce them. Although pillar 2 discusses the need for supervisors to intervene promptly if either a bank’s capital or the model used to cmpute capital are perceived inadequate and impose remedial action, no powers are explicitly recommended for supervisors to effectively enforce this mandate."
  

It should be expected that a campaign to reverse Basel 2, removing the requirement to comply for the largest "internationally active banks". It also shows that the current targeting by the Fed to bolster reserves and capital assets of Banks and Primary Brokers may well be the first step to undermining Basel 2, removing the restrictions and allowing previous practises to return.

Policy changes designed to feed cash or equivalent assets directly to consumers via tax rebates or Federal and Govt sponsored "respite" programmes along with the undermining of Basel 2 "restrictions" would appear to be the main weapons in use in an attempt to cushion the effects of the current recessionary tendencies that might interrupt the recovery from 2000-03.

The cooperation of the Federal Reserve, US Treasury and the Government in fighting against any deflationary forces resulting from the credit crash is the biggest regime change seen since 1933. Whilst the policies are now in place and active, showing a credible approach to re-inflation, the real test lies ahead.

Will the concerted actions have the desired effect upon consumers and business and allow their inflation expectations to grow?

We shall see.

Having written 2 in-depth articles about the rationale behind the Federal Reserve and US Govt plans to bail out the financial system some readers of the last couple of Occasional Letters may well have wondered if I was about to change my outlook. This article should put paid to any such thoughts.

Previously I looked at the evidence that supported the view that the Fed and US Govt (along with the Bank of England) are following a monetarist approach, adapted by GB Eggertsson , to attempt to re-inflate the economy through non traditional means. As we have seen, especially recently in the UK, all the mechanisms required for the plan are in place and are being instigated.

In this article I want to look at why the monetarist approach will fail and what the results of that failure will be. (Yes, this is the article you have been waiting for). In doing so, I may quote from others but I shall make it clear when I am doing so.

First and most importantly, I must stress that my long term outlook remains unchanged:

• A recap of the scenario: bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.

Now the next bit might sound a little patronising for which I apologise in advance, I know my readers are a clever bunch and this could be seen as pointing out the obvious.

Read the scenario again. Within it is a wisdom that could form a theory all of its own (I know, I'm getting carried away) and would explain many of the observations about the economy and stock/bond markets.

Here is the patronising bit. To circumvent the final outcome of the scenario, which is the biggest fear of the Fed et al, the central planners have a "cut out". Simply put, when they judge circumstances may lead to the dreaded conclusion; they stop the process by resetting it to the beginning. They rewind the tape.
Is this my way of saying that the deflation will not happen? No, it will occur when the tape snags and breaks. What we are living through now is an attempt by the Central Banks, in cooperation with their Governments to reset conditions back to "easy money". In other words every attempt to avoid a deflationary period results in a series of actions that make the requirement for the same actions to reoccur, the only difference being that the size of each "action" has to be larger than the previous one.

It is the infinite Ponzi scheme. Whereas a normal Ponzi scheme requires investors to keep ploughing in new money, the infinite scheme is only regulated by the pace of newly created money introduced to the scheme as the fiat system guarantees supply.

Let us see this in action by examining other periods when the tape was rewound.

Firstly here is a chart of inflation/deflation swings from Jan 1914 - Mar 2007. Although a year behind, it shows well the current long term trend (Dept of Labor/BLS):

Most noticeable is the smoothing of inflation peaks and deflation lows, with the elimination of deflation by the mid-50's. This remarkable achievement is even more apparent in this chart (using McCusker to 1913 then as per previous chart):

Never has the elimination of deflation or such a sustained period of inflation been seen in the past 350 years. We truly are in an age of innovation. Without doubt, it is the elimination of deflation that is the Fed mandate, accomplished by a continuing inflation which is controlled in its acceleration by the application of interest rate policies:

Now for most that read my Letters none of this is particularly earth shattering news, for the uneducated public though this would come as a shock. The recognition that the past 50 years are aberrant, not the norm, is like saying the deflationary outcome of the 30's crash was "unexpected". There is no doubt that the deflationary period in the Great Depression was not unusual. What is unusual is the persistence of inflationary conditions since the mid-50's.

Some will say that it was the loss of a gold or silver backed currency that caused this unusual inflation, others that the social and economic ills of the 30's made episodes of deflation unacceptable to the politicians and public.

Although both points could offer contributory causes to the current inflation, it would not explain the acceptance and appearance of both inflation and deflation prior to the mid-50's. What may explain the disappearance of deflation is the rapid and innovative use of debt.

Who initiates and allows the accumulation of debt?

The above chart show recessions marked with gray columns. You can now see why I compared the current Fed conundrum to 1937 and not 1933. Notice the acceleration of debt at each recession. The one time that debt accumulation slowed, in the very late 90's, it led to the closest meeting with deflation since....the mid 50's.

It is the increase in debt, the enabling of "easy money" coupled with a falling real interest rate environment that allows a new wave of inflation to begin. The trigger is any threat that a deflationary period might occur, regardless of the cause of the recessionary events.

Why, in the face of such evidence, do I then hold onto a deflationary outcome? Am I saying "its different this time" ? Or have you already forgotten that the current conditions have only existed for the past 50 years?

Unlike any period since the 30's we are now living with a credit contraction, were even extraordinary measures carried out by Central Banks and Governments are only able to keep the status quo. Expansion of debt from its originator is now used to shore up positions (the Bank of England has forbidden any new positions be taken with Treasuries borrowed from the latest scheme) rather than initiate a further velocity of lending, a fractional enlargement of debt. Current debt is being rolled over, with the new collateral provided by the Central Banks. The acceleration of debt has been massively retarded, if not stopped completely.

It is this that has caused such extraordinary manoeuvres to have happened over the past 8 months, leading to a socialisation of the capitalist system. It is not bank losses or even closures that worries the Fed, it is the breakdown of the benign inflation mechanism by the withdrawal of credit mechanisms from the economy.

The following excerpt is from the August 2000 FOMC minutes (pg 82):

• "MR. JORDAN. Thank you. I agree that leaving the funds rate unchanged at this point is the right thing to do. I am also sensitive to the communications issues involved; it would not be desirable to communicate the expectation that we are not going to raise the funds rate in the foreseeable future or to imply that the next change might be down rather than up. But it is a challenge as to how to avoid communicating that.

  Regarding the language on the balance of risks, part of me would like to say that the statement should always be that an unavoidable, permanent feature of a fiat money system is a balance of risks toward higher inflation. [Laughter] If it ain't going down it's going up.

Some readers might remember the Mogambo Guru published a similar extract in one of his articles some time ago. It was I who sent it to him.

You noticed the laughter. It is poignant as much as alarming. It shows that the committee accept the words of Mr Jordan as a truism. It also means that any threat to an inflationary environment is seen as a threat to the very existence of a fiat money system.

The Fed is no inflation hawk, it is no defender of inflationary expectations. Inflation is a necessary tool to keep the monetary system alive. The Fed is a fighter of deflation, not inflation.

Inflationists are even now pointing out that all the Fed/US Govt needs to do is create new money or nominal interest rate bonds (as put forward by Eggertsson/Bernanke/Friedman) to allow new credit to be created. Indeed I fully expect such measures to be taken in the future.

There is however one difference between the current situation and that of the 30's. I give you this as an example:

• "BANGKOK (Thomson Financial) - Japan has turned down 60,000 tons of rice from Thailand after the asking price nearly doubled in the space of a month, the Thai Rice Exporters Association said Wednesday.

  Chookiat Ophaswongse, president of the association, said Thailand on Tuesday offered the Japanese government 100 percent white rice at $1,300 per ton -- up from the $720 it paid in March.

  "This time, Japan turned it down, saying that the price was too high for their budget," Chookiat said, adding that Japan did not want to be seen as a country pushing up global rice prices.
  

The implications of such actions by importers cannot be under-estimated. This is Japan turning down a staple food requirement for its populace because the price is too high. The reasoning is not important, it is the action and the implications for other exporters of other commodities that is.

We are seeing the beginning of price controls by buyers. If Japan is successful and eventually gets its rice at a cheaper price, the lesson will not be lost on other purchasers and not just those buying food stuffs.

If such actions become commonplace, price inflation and therefore inflation expectations would decouple from the requirements of the Central Banks. If prices start falling price inflation measures, already at peak y-o-y readings would drop drastically, undermining the Feds inflation rhetoric and therefore its plan to raise inflation expectations would lose credibility.

It is this loss of a credible inflation threat that would make further debt issuance by the Fed untenable. I refer you to this from "The Future Actions of The Federal Reserve And US Govt Are Known":

• "Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)

  "The third key result of the paper is that in a Markov equilibrium the government can eliminate deflation by deficit spending. Deficit spending eliminates deflation for the following reason: If the government cuts taxes and increases nominal debt, and taxation is costly, inflation expectations increase (i.e., the private sector expects higher money supply in the future). Inflation expectations increase because higher nominal debt gives the government an incentive to inflate to reduce the real value of the debt. To eliminate deflation the government simply cuts taxes until the private sector expects inflation instead of deflation."
  

The private sector will not expect inflation in the face of declining prices, if buyers follow the actions begun by Japan. During a period of recession it would be politically unacceptable to try and stop prices from falling from their currently elevated levels. It would not matter that the public and private business did not recognise the difference between price inflation and monetary inflation. Because of the carefully nurtured confusion over the 2 forms, the Fed would have great difficulty explaining why it was attempting to raise (monetary) inflation in a recession.

The Eggertsson plan would fail and deflationary forces would prevail sounding the death knell for the infinite Ponzi scheme.

Unless, of course, the Fed entered the commodities markets and bought everything it could. Then again, I doubt the US Govt has the stomach to be blamed for mass-starvation.

The past three Occasional Letters have been quite an in-depth discussion about the path taken by the Federal Reserve and recently by the Bank of England in their attempts to deal with the deflationary forces unleashed by the credit crash. Since those discussions we have seen evidence that supports my view as seen recently in the Weekly Reports.

This Occasional Letter will further expand upon that evidence and show why the plan, which I dubbed Eggertsson Theory, may already be showing signs of failure.

Firstly a little recap to refresh readers memories. GB Eggertsson wrote a paper for the Federal Reserve in which he supported the Monetarist view that deflation could be avoided by a combination of fiscal and monetary expansion combined with a credible expectation that the polices were inflationary. This would lead the private sector (business and consumer) to act in a manner that reflected such expectations and to respond to them accordingly.

It is the expectations of inflation that were of importance to Eggertsson, without it the plan to reflate would fail, as seen in Japan over the past 2 decades. Indeed, Eggertsson goes as far as to say (along with Bernanke) that the failure of the Bank of Japan to adopt an inflation target, either actual or implicit led to the current malaise affecting their economy.

As I mentioned in the previous articles, the Ben Bernanke Fed along with the US Govt and Treasury have adopted the measures espoused by Eggertsson and have implemented them. We have ample proof of the stimulus, tax rebates and new Fed Facilities, all designed to add liquidity in the form of cash and credit enabling structures to stave off a slowdown. During this period we have had constant reiteration of a hawkish view on inflation and the possible decoupling of inflation expectations to the upside.

Importantly then, have we seen an increase in inflation expectations in the people and the private sector? April Consumer Confidence as measured by The Conference Board dropped to 62.3 from 65.9 showing that the economy has yet to bottom. Within the report were 2 interesting figures:

• 1 year inflation expectations were 6.8% up from 6.1% in March.

Does this mean consumers expect to spend more? No it does not and as we shall see later, it would appear that rather than consumers stepping up to higher prices, they are buying less.

Here are a couple of snippets from the Consumer Confidence report that show more evidence of a lack of spending power and an increasing fear:

• Jobs Hard to Get 27.9% up from 24.5% in March, and Jobs Plentiful 16.6% down from 19.2% in March.

  The number of respondents planning holidays (vacations) are at a 10 year low.
  

Now expectations are one thing, actual changes in habits are another. We can see that the public perception of inflation is growing and by some measures could be viewed as having decoupled from the Fed expressed inflation expectations. This could only be seen by most as highly inflationary and that rises in workers compensation would have to go up to maintain equilibrium.

A self fulfilling prophesy, engendered by Fed/US Govt policies, that causes a rise in compensation and prices and a move away from deflation seems to be in the throws of creation. If we take the consumer inflation expectation at 6.8% and compare it to Fed Fund Rates at 2.25% then real rates are a negative 4.55%.

Yet the consumer does not seem to be interested in grasping this opportunity, even to fund a holiday.

• GDP +0.6%, but real final sales -0.2% (1st drop since -0.5% in Q4:2005). Consumption slowed on dip in durables & nondurables spending (only services were up), & investment fell except for inventories.
  

More from Thompson financial:

• (Thomson Financial) - The U.S. economy continued to sputter in the first three months of the year as consumers cut back on spending to their slowest pace since the mild recession of 2001, the Commerce Department said today.
  

Consumer spending grew at 1% yet reported Personal Consumption Expenditures rose 3.5%. Core PCE rose 2.2%. Now we have a dilemma for the Fed, in that although inflation expectations have risen, PCE and core PCE have not. In fact it they slipped back by 0.2% and 0.1% from Q4. (core excludes food and energy)

So by the Feds own measures, (it prefers core PCE) inflation is moderating. Now before I get a bunch of emails about using Fed data let me explain one thing. The Fed use Fed data. If you want to know what the Fed are thinking don't impose statistics that the Fed doesn't use.

So what does this tell us about consumers? It tells us they have stopped spending. Goods might cost more but they are not being bought in the same quantity. Remember, you can put whatever price you want onto an asset, it doesn't mean someone will be willing (or able) to pay it.

Blue = Real retail and food services sales. Red = CPI all urban consumers, all items. Green = CPI all urban consumers less energy.

What about business, did it continue to view the economy as it did in Q4?

• Exports grew 5.5 % after rising 6.5% in Q4 . Inventories added 0.81% growth after subtracting 1.79% in Q4.
  

No, it did not. Business decided to replenish inventories in Q1 '08 despite the evident slowdown under way and it wasn't to boost exports. Why would business do this, why change tack before real signs of change in the economy? Again we have to look at the Fed and US Govt and the constant rhetoric that favoured upside surprises in growth and inflation. It looks like business took them at their word. That might prove to be an extremely costly mistake if that inventory cannot be passed on to consumers.

The following chart shows why I am puzzled by the way Business conducted itself in Q1:

Clearly something has changed in the accounting of unfilled orders. Is it a ruse to push forward production into the accounts without actually realising the sales? Secondly, new orders and shipments are stagnating or declining and would not be conducive to an inventory build.

More worryingly for business is the consumer perception about the jobs market:

• Jobs Hard to Get 27.9% up from 24.5% in March, and Jobs Plentiful 16.6% down from 19.2% in March.
  

Even if the consumer is wrong, the expectation that jobs are under threat or that finding a job has become much more difficult will cause a retrenchment in spending. The tax rebate cheques hitting doormats may well find their way into savings accounts or the pay down of non secured debt rather than being used to buy consumer goods. If this does happen, business will find itself with a large inventory overhang and a lack of orders going forward.

Which brings us to cause and effect. What caused the consumer to retrench, to slow spending growth to below that of PCE? Simple, someone turned off the credit tap. Without doubt we are not seeing spillover effects from the credit crunch into the real economy, we are seeing a flood, a deluge of deflationary waves crashing into the cliffs of consumer spending. We know what happens next, the cliff crumbles and the waves move further inland, threatening greater erosion.

You see deflation is not just a negative reading of money/credit production or even a reading of falling prices. Deflation and inflation can be seen as the amount of money/credit available to purchase goods and pay for services.

It does not matter how the availability of money is affected, the result is the same. Taking money out of an economy, either through higher taxation, higher interest rates, higher prices or increased savings reduces the amount of money available to be spent on discretionary items or services. Only the basic necessities can have pricing power and even then the consumer may decide the necessity can be cut back.

Savings under an Austrian model economy are only useful if they are used to invest in production. For instance if the savings are hoarded, to bolster capital requirements, then no expansion of useful production is possible. In a deleveraging credit based economy, where the accumulation of capital is the highest priority, then credit based expansion becomes impossible.

We have seen this with housing and automobiles and now we are beginning to see it with all purchases outside of the service sector (BEA):

• Real personal consumption expenditures increased 1.0 percent in the first quarter, compared with an increase of 2.3 percent in the fourth. Durable goods decreased 6.1 percent, in contrast to an increase of 2.0 percent. Nondurable goods decreased 1.3 percent, in contrast to an increase of 1.2 percent. Services increased 3.4 percent, compared with an increase of 2.8 percent.
  

The economy is stumbling along on one good leg. If it twists the overburdened limb it will come to an instant and painful stop.

As the consumer "drives" GDP we need to see what the trend is in their habits (BEA):

• Disposable personal income increased $127.3 billion (5.0 percent) in the first quarter, compared with an increase of $103.4 billion (4.1 percent) in the fourth. Real disposable personal income increased 1.4 percent, compared with an increase of 0.1 percent.

  Personal outlays increased $106.8 billion (4.2 percent) in the first quarter, compared with an increase of $148.0 billion (5.9 percent) in the fourth.

  Personal saving -- disposable personal income less personal outlays -- was $20.2 billion in the first quarter, in contrast to a negative $0.3 billion in the fourth.

  
  The personal saving rate -- saving as a percentage of disposable personal income -- was 0.2 percent in the first quarter; in the fourth quarter, the personal saving rate was 0.0 percent.

Spending less, saving more.

The economy now finds itself staring at the last true hope for salvation, the tax rebates. Will the consumer spend those tax rebates or will the money, delivered directly to the consumer (as per Eggertsson Theory) be used to pay off debt and/or be placed into savings?

It is clear that even the Fed/US Govt isn't sure on the outcome. Yet another "save the mortgage" scheme is being muted:

• US HOUSING: Federal Deposit Insurance Corporation Chairman Sheila Bair outlined in an Op-Ed piece in today's Financial Times a proposal that would assist one million homeowners who are facing foreclosure. The plan proposes that Congress authorize the U.S. Treasury to use $50 billion to make loans to borrowers with unaffordable mortgages to pay down up to 20 percent of their principal. The repayment and financing costs for these Home Ownership Preservation (HOP) loans would be borne by mortgage investors and borrowers. This approach is scaleable, administratively simple, and will avoid unnecessary foreclosures to help stabilize mortgage and housing prices.
  

For the Fed et al time is running out. With PCE inflation measures showing signs of moderation the credibility of the touted inflationary policies becomes more difficult to defend. Consumers have been fed a diet of higher inflation expectations and are reflecting as such but there seems to be resistance to actually commit to higher spending. That resistance will grow if signs of further moderation in inflation appear and spending will be suspended until prices fall to acceptable levels.

If spending does not increase business may decide that the Feds inflationary expectations are misplaced when compared to what their till receipts tell them. If business then decides to cut overheads and raise productivity by cost savings, allowing prices to fall to attract sales, the Fed will have failed and a deflationary environment will be established.