Saturday, July 24, 2010

Deflation - Month CPI trend

Econbrowser: Fighting deflation
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The Bureau of Labor Statistics reported Friday that the seasonally adjusted consumer price index declined in June to the lowest level since November. When we start to talk about the level of the CPI rather than its rate of change, you know that deflation could once again become a key concern.

In normal times, the Fed faces a trade-off. It would like to stimulate the economy to help bring about faster output growth, but worries that the result might be too much inflation. But once we get into a regime of falling prices, those negative inflation rates can be damaging in and of themselves. With the price level currently falling and the unemployment rate alarmingly high and persistent, if there ever was a time when the Fed wanted to push down the gas pedal, now would be it.



So why doesn't it? The traditional tool by which the Fed stimulates the economy is to increase the reserves it supplies to the banking system in order to bring down the fed funds rate, which is an interest rate on overnight loans between banks. But with that interest rate now effectively at zero and banks holding excess reserves over a trillion dollars, that traditional tool has become completely irrelevant. Conventional open market operations, in which the Fed purchases T-bills with newly created reserves, are just exchanging one asset (T-bills, a short-term liability of the Treasury which pays a near-zero interest rate) for another virtually identical asset (reserves, a nominal liability of the Fed which pays a near-zero interest rate), with no consequences for any private-sector decision.



The claim that a central bank could become completely unable to debase the currency if it wanted has always seemed odd to me. Even if reserves and T-bills become equivalent assets (and at the moment they surely are), reserves are not equivalent to any number of other assets. Nothing prevents the Fed from buying longer-term assets, continuing to create reserves at will for the purpose until the yields on those assets adjust. And yet, the Fed has bought over a trillion dollars worth of mortgage-backed securities, and we're still not where we want to be.



Or for that matter, the Fed could start buying goods directly, or equivalently, let the Treasury buy the goods and have the Fed simply buy up all of the debt that the Treasury cares to issue. That the price of goods would be unaffected regardless of the quantity purchased seems quite implausible....

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bth: we've got real problems. With deflation there is a disincentive to invest in plant and equipment, in expansion, in people, in commodities. The producers, the people that invest begin to get hurt, they disinvest, the banks have an incentive to just sit by on their zero cost assets from the fed and watch the economy unwind. We have got to change this as soon as possible. This original article had some interesting ideas on what the fed might do. Let's hope someone is reading it.






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