A common slogan by economic pundits is that the Federal Reserve is "out of bullets" when it comes to monetary policy. They note that the Fed funds rate is already at 0% and QE 1 has failed to stimulate the economy. With banks not lending the Fed has fallen into the dreaded liquidity trap as de-leveraging mitigates expansionary monetary policy. The pundits say that we are destined to end up like Japan and stagnate for 20+ years in a deflationary environment. What people forget is how devilishly creative Ben Bernanke is when it comes to monetary policy. But what choices are left for Zimbabwe Ben?
I have outlined a few possible tools still available to the Fed:
1. Dramatically Change Price Expectations---Recent Fed announcements indicate that they want a 2-3% inflation rate compared to the current 1% rate. One idea is for the Fed to increase its inflation target upward to between 4-6%. To support this new policy the Fed could openly announce that they are monetizing debt rather than calling their money printing credit easing. The Fed could also buy new kinds of assets such as stocks, corporate bonds, land, etc. This could have the effect of stimulating spending as consumers and businesses fear the loss of purchasing power. It would make it clear that the Fed is serious and will do everything in its power to create inflation.
2. Cap Treasury Rates--Under this policy option the Fed would agree to cap treasury rates at unreasonably low rates (e.g 10 year at 1.5% and 30 year at 2.5%). They would openly announce the target to the market and state that they will print as much money as necessary to achieve the goal. This would have the effect of lowering the real inflation adjusted yield of the 10 year to near zero. It would reduce the incentive for financial institutions to hold Treasuries and force them to do something with their money.
3. Taxing Currency---- Under this option the government would tax the currency , meaning that the dollar would automatically lose value over a period of time (say 3% every 6 months). This would create a cost to holding currency, giving people and institutions an incentive to spend it quickly, which would increase the velocity of money throughout the financial system. An extreme example of this policy would be the introduction of a new currency which would lose a certain amount of value over a fixed period of time. The Japanese government considered this option in 1999, but never implemented it.
4. Negative Interest Rates--Like taxing currency this option imposes a cost of holding money and theoretically forces people and corporations to spend money which would increase aggregate demand. However this is a hard policy to implement from a political perspective. It could lead to a flight of capital from the US as savers abandon the dollar for foreign assets. Under this policy option you may have to implement capital controls. What could work is for the Fed to impose negative interest rates on bank deposits held at the Federal Reserve. They could also prevent banks from passing along negative interest rates to consumers. Banks would be forced to do something with all of the money they are hoarding. This policy option would give banks an incentive to lend to the economy.
5. Helicopter Drop Money--The easiest way to stimulate aggregate demand is to print money and hand it out to the general population. Imagine everyone in the US getting a check for $5,000. This would automatically create inflation and increase spending. It would also increase inflation expectations which the Fed considers important. The major drawback is that nobody knows how much inflation this would cause and it might lead to hyperinflation.
As you can see the Fed is not out of bullets. Please remember, I do not advocate any of these policy options, but fully expect the Fed to try some of these if it looks like we going the way of Japan. The Federal Reserve will stop at nothing to create inflation and destroy the value of the dollar, all in the name of saving the economy.
Black Swan Insights