Deflation, Reflation, Inflation

In our September 28 Salvo, we imagined an opportunity to ask Chairman Bernanke the following question: “What does the Fed do if it expands its balance sheet to $4 trillion or $6 trillion, drives the 10-year yield down to 2% or less, but unemployment still stands around 10%?”

The question reverberates more loudly every day closer to the November 3 FOMC meeting, at which we expect the Federal Reserve to provide more details on its plans for another round of large scale asset purchases (LSAP2).

It turns out that Chairman Bernanke anticipated our question back on May 31, 2003, in a speech delivered before the Japan Society of Monetary Economics. The speech, which is overshadowed in central banking lore by Bernanke’s infamous 2002 helicopter speech, is a remarkable example of an American policymaker “advising” the Japanese on how they can fix their problems. The 2002 speech has been used by the market as a roadmap of sorts to understanding Bernanke’s thinking regarding the toolbox of unconventional policy methods in a zero interest rate environment. The 2003 speech spells out what to do when all the tools are out of the box. Perhaps a new map for a new road.

He started by saying that the primary objective of monetary policy in a deflationary period is to not only spark inflation but to increase the price level (as measured by an index like CPI) to a level where it would have been if it had continued to rise at the desired rate of, say, 2% per year. This is akin to price-level targeting, not inflation-rate targeting. The Bank of Japan, he said, needs to commit to restoring price levels by initiating asset reflation—a period of inflation above the long-run preferred rate of inflation—to the targeted level. Importantly, however, that commitment must be made by communicating that the policy stimulus won’t be withdrawn as soon as inflation returns to the desired level. He said, “[I]t would be helpful if the zero-interest-rate policy were more explicit about what happens after the deflationary period ends.”

The commitment to reflate the price level must be backed up with action, and this gets us the answer to our question about what the Fed will do if its balance sheet expansion isn’t working. A price level target is unforgiving in that the targeted price level marches onward and upward, year after year.  If the central bank fails to make the target, the target gets higher. “[T]he public expects the leaders of the central bank to take more aggressive actions, the further they are from their announced objective….Thus, failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods—greater quantities of assets purchased on the open market, for example.”

Perhaps one question to ask Chairman Bernanke at this point is whether reflation, which may be the right idea when there is outright deflation, is still the right idea if in fact there is inflation. Another would be to sketch out the transmission mechanism between reflation and employment. But we digress.

The next thread of the speech focuses on what it means, from a risk perspective, for the central bank to balloon its balance sheet. “[T]he BOJ’s most recent financial statement showed that of the 68% of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs). This represents a very substantial increase over customary levels in the BOJ’s holdings of long-term government debt. Because yields on government bonds are currently so low, these holdings expose the BOJ’s balance sheet to considerable interest-rate risk (although any losses would be partly offset by unrealized capital gains on earlier acquisitions of bonds). Indeed, ironically, if the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates.” The graph below matches up the qualitative easing programs of the Bank of Japan and the Federal Reserve by date of launch. In QE2, the Federal Reserve’s line will get another leg up.

Bernanke conceded that a central bank is not a private institution and therefore not subject to the same risk management requirements. “[T]he Bank of Japan is not a private commercial bank. It cannot go bankrupt in the sense that a private firm can, and the usual reasons that a commercial bank holds capital—to reduce incentives for excessive risk-taking, for example—do not directly apply to the BOJ….[O]ne could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy.”

This is cold comfort to the investors who were likely in the same boat as the BOJ….and the same can be said for an investor today who is invested in dollar-based fixed income instruments. Bernanke’s prescription for the central bank loading up on long duration assets to achieve its policy objective is essentially to enter into massive amounts of interest rate swaps with the Ministry of Finance. Think of it like the Fed swapping with Treasury, where the effects on both sides of the swap are cancelled out.

The last part of Bernanke’s plan is a cooperative effort by monetary and fiscal policymakers to consider a tax cut that is financed by money creation. In other words, increase the wealth of the private sector through the tax cut, increase GDP growth through increased consumption, and debt growth is absorbed by the central bank.

It all works out, in Bernanke’s speech, but he mentions one caveat. “Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government’s fiscal position.”

To repeat: “… one can never get something for nothing.”