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US Fed Zeroes in on Deflation

The Federal Reserve might not want to admit that its shocking decision to cut its benchmark interest rates to a record low or virtually to zero per cent was to steer the US economy clear of deflation. But the fact is that most Fed officials did not believe the economy would slip into recession until only a few months ago. However, data recently confirmed that the economy was in fact in recession since last year. And that was the year when Fed officials were flying around the world making comments about the risks inherent in monetary policies of Asian central banks. Asia is now sitting on a near $4 trillion of hard cash and the Fed is printing money — buying securities, treasury bills and mortgage-backed debt and consumer loans etc, and has also launched a slew of lending schemes to improve mortgage and credit market conditions. This happens to also expand the Fed’s balance sheet, now standing at more than $2 trillion from about $900 billion in September, and on its way to hit $3 trillion by some estimates.

The zero-rate policy looks very similar to what Japan used for about six years, starting early 1999, in its own fight against deflation. Fed doesn’t want to admit that as well. After the rate cut a senior Fed official, in an unprecedented ‘off-the-record press briefing’ (thought to be an Asian trait), told reporters in Washington that deflation was not a major concern at this juncture but signals determination to improve lending conditions by narrowing spreads. Of course demand for interbank loans, which usually trade above the Fed’s benchmark rate, has been so low that the actual federal funds rate had been far below the target for a month and hovered at barely 0.1 percent in the last several days. But that spread and the low demand for credit tells you more about the crisis of confidence in the market and the loss of credibility the Federal Reserve has suffered.

The Bank of Japan’s quantitative easing strategy during the country’s decade of economic stagnation and deflation during the 1990s was also criticised for being too little, too late. And just like Japan, there is no lack of money in the system. In fact banks are simply hoarding cash. While the Fed may not have any other choice but to use its printing press, and expand the monetary base, the question is who would mop up the excess money created. Fighting deflation with zero-cost money sounds easy, but fighting inflation could prove elusive.

The only silver lining in this case is President-elect Barack Obama’s Keynesian expansive fiscal policy under which the government would borrow billions to boost state spending and make up the decline in private consumption.

However, one big lesson from Japan’s lost decade was that Keynesian policy per se did not work due to the collapse of asset prices. Unless the housing market in the US hit a bottom, both consumers and lenders would stay put. If people and corporations are unwilling to borrow and if banks are disinclined to lend, central banks cannot force them to do so. During deflation, they cannot even induce them to do so with a zero interest rate. Thus, regardless of assertions to the contrary, the central banks’ purported “control” of borrowing, lending and interest rates ultimately depends upon an accommodating market psychology and cannot be set by decree.

For us, here in the Middle East, an ailing US economy, which represents about half of the world’s gross domestic product, is certainly not good news given the economic linkages that have grown a lot stronger in the last six years. More troubling would be what happens to the US dollar, which can also go the way the Japanese yen went.

Low or zero short-term interest rates could keep the dollar weak against other major currency, which means lower earnings for oil exporters in the region. In the worst case scenario, the US dollar could turn into a funding currency - one which speculators would borrow cheaply and use it to buy a currency that has a higher yield. While most currencies in the region are pegged to the dollar, interest rate differentials have emerged as in the case of the UAE dirham, opening doors to disruptive arbitrage trade.

Any appreciation bias in the currency, when most of the world is in recession could be disastrous.