In memory of Dr. Andreas Höfert

There is still one more weapon in the Fed’s arsenal

| Tags: Andreas Höfert

The “shock and awe” monetary policy that the US Federal Reserve has deployed since 2008 might have surprised many, but not those who remember a speech that current Fed Chairman Ben Bernanke, then a member of its board of governors, gave in 2002.

“Deflation: Making sure ’it’ doesn’t happen here,” which earned him the nickname “Helicopter Ben,” outlined several years before the fact what the Fed would do when confronted with the 2007–08 financial crisis and the deflationary risks it posed. It is still too early to assess this policy because we have only seen the first part of it. As Anna Schwartz, the Grande Dame of monetary economics, wrote in 2009: “It is standard practice for a central bank like the Federal Reserve to ease monetary policy to combat a recession, and then to tighten it as recovery gets under way. Mr. Bernanke so far has only had to do the first half, and has conducted a policy of extreme ease.” Bernanke, who will leave office in January 2014, might enter history as the first Fed chairman never to have tightened during his terms.

That said, even the success of the easing remains in doubt. True, the US appears to be in no danger, as some other countries are, of falling into a double-dip recession, and slowly but surely unemployment is retreating. Moreover, the stock market is currently chasing one record high after another.

However, in recent months US inflation rates have been trending lower. Currently, both the headline consumer price index and the core personal consumption expenditure price index, the Fed’s favorite inflation measure, are declining toward the 1% annual growth rate threshold. If this trend continues, renewed deflation fears could reappear soon.

One reason is the rather significant decline in commodity prices, which in turn can be explained by lackluster global growth. Indeed, first-quarter GDP figures indicate that, while the US economy was reaccelerating, the growth rate of many emerging markets, especially China, was failing to gain momentum. Even worse of course is the situation in Europe, which remains in recession if not depression. Should this situation continue for much longer, it could jeopardize all the Fed’s efforts to ensure that “it doesn’t happen here.”

However, the Fed still has one more weapon in its arsenal – the ultimate one that Ben Bernanke referred to in his 2002 speech: “[…] the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of US government debt.” Hence, nothing could prevent the Fed from doing the job the European Central Bank (ECB) refuses to do or only agrees to do in exchange for even more fiscal tightening (through the outright monetary transactions scheme) in the peripheral countries: buying the government bonds of Spain, Italy, et al. to ease monetary conditions there.

Obviously, as Bernanke is well aware, such an intervention would “have the potential to affect a number of financial markets, including the market for foreign exchange.” However, in a world of currency wars, where Japan just fired the most recent salvo and the euro remains the stealth fighter, such a hypothetical ultimate intervention could finally lure the euro out of hiding and confront the ECB with the fact that the self-induced European depression is not an isolated event but one that affects the worldwide recovery.