The Issue Of Deflation

On the UK Telegraph: Deflation on the prowl as Bernanke shuts down his printing press

• By Ambrose Evans-Pritchard
  Published: 6:35PM BST 04 Apr 2010
  
  The US Federal Reserve has completed its purchase of $1.7 trillion (£1.1bn) of mortgage securities, agency debt and US Treasuries, the conjuring trick of "credit easing" that allowed Ben Bernanke to create stimulus equal to 12pc of GDP.
  
  The Fed's money creation has been more or less the size of Washington's borrowing needs for the last year, as Beijing notes with suspicion.
  
  We will never know whether it was wise to go nuclear. My view – anathema to readers, I fear – is that Ben Bernanke and Britain's Mervyn King saved us from potential calamity. We were all too close to the tipping point illustrated in Irving Fisher's Debt Deflation Causes of Great Depressions, the moment when the sailing ship catches water and capsizes instead of righting itself by natural rhythm.
  
  Work by Berkeley Professor Barry Eichengreen shows that global trade, industrial output, and stock markets all crashed at a faster rate over the six terrifying months after the Lehman crisis than during the early 1930s. How quickly we forget, and how easily we are seduced by a 76pc stock rally into thinking it was a storm in a teacup. Just wait until the day fiscal retribution comes.
  
  The $1.7 trillion created out of nothing will vanish as the bonds are sold on the open market. Not too quickly, let us hope. Easy money must cushion the blow of spending cuts. Even talk of ending QE amounts to tightening. While the US economy has begun to create jobs again – plus 114,000 in March, stripping out short-term census workers – there were false dawns in 2002 and 1982. The broader U6 jobless rate nudged up to 16.9pc.
  
  Bond vigilantes ask who will step into the Fed's shoes to soak up the flood of debt from Washington, whether from the Obama Treasury or from Fannie Mae and Freddie Mac – the mortgage giants on death row.
  
  Yields on 10-year Treasuries have jumped 30 basis points in two weeks to 3.94pc. Alan Greenspan called it "the canary in the mine" for US sovereign debt.
  
  The yield spike is happening even though core inflation (trimmed mean PCE) has been dropping like a stone, touching a record low of 1.04pc in February. The Fed's Monetary Multiplier is languishing at 0.815, a flat tire.
  
  The basic 30-year fixed mortgage has risen to 5.08pc from 4.71pc in December. The US housing market looks too sickly to withstand this. New home sales have fallen for four months in a row, dropping to a half-century low in February. The inventory of unsold homes has jumped to 8.6 months supply. Some 24pc of mortgages are in negative equity.
  
  Mr Bernanke is taking the fateful decision to knock away the props of the mortgage market even though the M3 broad money supply has been contracting at an epic pace of 6pc since September. If M3 gives early warning of six to 12 months, beware.
  
  Mr Bernanke does not look at M3, disdaining such monetarist eccentricities as medieval sorcery. The M3 signal has certainly been erratic over the years. It can be distorted by portfolio shifts. But the refusal to even look at it has been the root of much trouble over the past four years.
  
  Had Mr Bernanke paid attention, he would have seen the need to pop the credit bubble earlier. He would also have avoided his catastrophic error in the early summer of 2008. Robert Hetzel, chief economist at the Richmond Fed, writes in Monetary Policy In The 2008-2009 Recession that central banks themselves triggered the crisis by failing to cut rates fast enough as the economy tanked from March to July 2008.
  
  Cast your mind back to that moment. Rates had already been slashed from 5.25pc to 2pc. Oil and copper prices were rocketing. Inflacionistas were screaming, accusing the Fed of 1970s debauchery and some Fed hawks seemed to agree.
  
  Dr Hetzel said the Fed "effectively tightened" policy in June 2008 by tough talk that led the futures market to price in a half-point rate rise by September 2008. Evidence that the growth rate of broad money had long been plummeting was ignored.
  
  The European Central Bank went further, raising rates in July even though the eurozone was already deep in recession. We know what happened. Lehman, AIG, Fannie and Freddie fell apart in September. The wheels came off the world's financial system.
  
  My fear is that the Fed will repeat the mistake – in this case by reversing QE too soon. The problem is Mr Bernanke's ideological doctrine of "creditism".
  
  Is the Fed chairman worshipping a false religion? Was Milton Friedman right in arguing that the quantity of (broad) money is what is what matters most, not the credit mechanism?
  
  Upon this abstruse doctrinal point will depend – perhaps – whether the Atlantic economies rise above stall speed or lurch into a double-dip recession.