The Fed's Opponent: Deflation (Michelle Gibley)

by Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research
September 22, 2010

Key points

  • Due to the threat of deflation, or falling prices, the Fed stands ready with an open checkbook.
  • We recognize the downside risks, but believe the United States will avoid a double-dip recession.
  • Helpful information for all investors.

The Federal Reserve is charged with promoting maximum employment and price stability, and the economy is falling short on both accounts. In yesterday's statement, the Federal Open Market Committee (FOMC) stated that inflation is currently at levels "somewhat" below the level consistent with its mandate.

As such, the committee members indicated that they are prepared to "provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate."

With the fed funds target rates already at 0-0.25%, the Fed's most likely form of additional accommodation would come in the form of asset purchases of bonds, commonly known as quantitative easing (QE).

The goal in the first round of QE was to lower the cost of borrowing across private markets and thus support economic growth, given that many interest rates are tied to Treasury rates.

The case against more QE

Those arguing against more QE cite the ineffectiveness of the first program, in which the Fed spent $1.7 trillion purchasing assets. However, banks continue to hold nearly $1 trillion in excess reserves.

The problem is two-sided:

  • Banks face higher capital requirements, less creditworthy borrowers, and have raised lending standards.
  • Consumers are reducing their spending and shunning debt.

Richard W. Fisher, President of the Federal Reserve Bank of Dallas, has said that large-scale purchases may be "pushing on a string."

Kansas City Fed President Thomas M. Hoenig is concerned the Fed may be unable to effectively control rates when it comes time to tighten, because the already-elevated level of reserves could quickly multiply in the economy when confidence, economic growth and lending return, generating inflation.

Additionally, there are uncertain longer-term implications with using QE because, historically, there are limited examples of its use.

Meanwhile, Minneapolis Fed President Narayana Kocherlakota believes that a mismatch between jobseekers' skills and business needs is responsible for 2.5% of the current unemployment rate, and that this mismatch is not "readily amenable" to monetary policy tools, citing instead programs to address job retraining and foreclosure mitigation.

Debt hangover

Although it's good for individuals to reduce their debt burdens, when it happens en masse, as is happening now, it complicates monetary policy.

In the period running up to the recession, economic growth was boosted as individuals took on more debt or borrowed money from their homes, enabling people to spend more money than they had. Now, with nearly one in four homeowners underwater on their mortgages, the opposite could happen—economic growth driven by consumers could be below income growth.

Currently, the amount of money the Fed injects into the economy by expanding its balance sheet is being offset by debt reduction, effectively taking money out of circulation.

The case for more QE centers on deflation

In the Fed's June forecast, which will be updated in the minutes from yesterday's meeting, the Fed estimated that unemployment will remain between 8.3-8.7% in the last quarter of 2011.

Meanwhile, the Fed forecast assumes an acceleration of gross domestic product (GDP) growth to 3.5-4.2% in 2011, while the Bloomberg survey of economists estimates a deceleration to 2.5%.

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