WHEN ZERO IS TOO HIGH

INTERVIEW: The Fed's Deflation Defense: Federal Reserve governor Ben Bernanke doesn't predict deflation, but says that the Fed is well prepared to combat it (Ron Insana, August 2003, Business 2.0)

Q. Is the public commentary from folks like yourself [Fed governor Ben Bernanke, a former Princeton economics professor who is highly regarded not only for his keen intellect but for his expertise in combating tough economic problems with unconventional measures] part of an educational process to get people to think a little bit differently about how the Fed will operate going forward?

A. I began to talk about deflation because I heard, in the media and among the public, the concern that the Fed would run out of ammunition once the federal funds rate [the short-term interest rate that the Fed targets when it wants to stimulate or dampen economic growth] came down to zero. I was interested in educating the public that there were other tools the Fed could use to counteract deflationary pressures even if the federal funds rate were zero. We don't think that deflation is likely, but we want the public to be reassured that we're alert to the possibility, because it's important that it be prevented in the first place.

Q. What are those tools?

A. The Fed's normal operations involve purchases of government securities, which affects the federal funds rate. If we got to a point where short-term interest rates were at or near zero, then the next line of defense would probably be to try to lower longer-term government bond interest rates--for example, interest rates on five-year Treasury bonds.

There are several ways to approach doing that. One way would be to try to explain to the public that we intended to keep the short rate at a low level for a long period of time, which in turn would persuade holders of bonds that medium-term interest rates would remain low. That policy can be supplemented, if necessary, by a program of buying medium-term bonds at the targeted interest rate, as well as by other measures. [...]

Q. We haven't seen deflation in the U.S. since the Great Depression in the 1930s, but Japan has been mired in a deflationary spiral for a long time now. Why is deflation so intractable there?

A. Even though very short-term nominal [not adjusted for inflation or deflation] interest rates in Japan are zero, because of deflation real [adjusted] interest rates are still 1% to 2%. Given the very weak level of aggregate demand in Japan, arguably real interest rates ought to be negative. Monetary authorities in Japan are being prevented by the so-called zero bound [the inability of interest rates to fall below zero] from easing policy as much as would be desirable under other circumstances to support investment and consumption in Japan.

Q. What's the central bank to do when interest rates hit zero and its traditional method of influencing the economy isn't effective anymore?

A. Again, the first option is to try to lower medium-and long-term interest rates. Then there's a series of other options one can undertake, including buying other kinds of assets besides Treasury bonds. The Japanese have explored some of those possibilities as well, purchasing asset-backed commercial paper, for example. The ultimate option, as I recently suggested to the Japanese, is for the central bank to cooperate with fiscal authorities and combine tax cuts with increased money supply. Essentially that amounts to handing out money to consumers, which will generate increased spending and ought to raise prices within the economy.

Our economist friends swear that if you just put more money into an economy prices will necessarily rise. We remain to be convinced that this is the case when population is falling, when a combination of globalized job markets and technology are lowering production costs, and when lowered trade barriers foster global competition for customers. Posted by Orrin Judd at July 17, 2003 8:17 PM