So here we have it near zero interest rates in the United States for the first time ever, the Federal Reserve reduced the federal funds rate, the interest that banks charge each other, to a range of zero to 0.25 percent. That is down from the 1 percent target rate in effect since the last meeting in October. So why such an aggressive cut? The reason banks simply are not lending despite the stimulus package credit is not flowing from the banks into the economy. The banks are busy shoring up balance sheets and have dropped the ball, so the Government “the lender of last resort” has an even more aggressive plan they plan to flood the economy with billions of dollars by doing so the banks will be awash with cash and will in turn start lending again. This experiment is not without risks. There is the potential for very high inflation down the line if the Fed is successful. But, does the Fed have a choice? It seems that it is looking at deflation or depression on the one hand or stagflation on the other. Take your choice.
This method of flooding the economy with money (or simply turning on the printing presses) is known as Quantitative Easing. Quantitative easing was a tool of monetary policy that the Bank of Japan used to fight deflation in the early 2000s.
The BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. More recently, the BOJ has also been flooding commercial banks with excess liquidity to promote private lending, leaving commercial banks with large stocks of excess reserves, and therefore little risk of a liquidity shortage.
The BOJ accomplished this by buying much more government bonds than would be required to set the
But this policy of excess money supply leads to inflation right? Yes we just have to take a look at Zimbabwe and notice how they have got it horribly wrong and now have rampant hyper-inflation and a worthless currency they simply lost control and did not have the expertise in controlling money supply.
Printing money is effective because it has the effect of putting more high-powered money into circulation. The aim is to increase bank reserves enough so as to increase lending that results from those reserves.And Fed Chairman Ben Bernanke knows this. He is a student of the Great Depression and deflation, a well-regarded economic historian. Bernanke earned the moniker “Helicopter Ben” a few years back as a result of some comments he made in 2002 at the National Economists Club regarding quantitative easing to avoid deflation before he became the Fed Chairman. Here is what he said as quoted on the Federal Reserve’s website:
“As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero–its practical minimum–monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But 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.
Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But 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.
Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”
So what happens now? Well the Dollar will weaken it will buy less, President Elect Obama for his stimulus package will spend Trillions not billions as he and the Fed will do what ever is necessary to kick start the US economy. The concern right now is to get these banks lending, also to contain the deflationary spiral. Consumers need to start spending and whilst the markets like the rate cut we have now entered unchartered waters. I like the plan, well at least the Americans have a plan, we here in Euro land just talk a good a lot and show very little action.
Mr. Bernanke the whole world hopes your gamble comes off…
No comments:
Post a Comment