Weekly Markets Commentary – December 1, 2008

David Joy — Chief Market Strategist, RiverSource Investments

Foreshadowing the Fed's Response to Deflation

As evidence builds that economic conditions continue to deteriorate, and with the October Consumer Price Index falling the most since records began in 1947, questions have been raised about the risk of an emerging episode of deflation in the U.S. With the Fed Funds rate already targeted at a meager one percent, some also are asking if traditional monetary policy is running out of effective tools. The Fed meets again December 15-16 and the futures market anticipates a cut in the overnight rate of as much as one-half percent.

On Nov. 21, 2002, then Federal Reserve Board Governor Ben Bernanke gave a speech to the National Economists Club in Washington, D.C., in which he outlined the additional policy steps that could be taken once the target rate had reached zero. This was the speech that earned him the nickname "Helicopter Ben," although he was quoting economist Milton Friedman when he said that central banks, in a system with a fiat currency, could simply drop money from helicopters to get consumers spending again.

Of course, economic conditions were quite different when the speech was given. In considering the possibility of a deflationary episode similar to the one Japan experienced during the early 1990s occurring in the U.S., Mr. Bernanke cited the structural resiliency of the U.S. economy and the strength of our financial system. Concerning the latter, he said, "Despite adverse shocks of the past year, our banking system remains healthy and well-regulated and firm, and household balance sheets are, for the most part, in good shape." Obviously times have changed, making the Fed's role in fighting a deflationary scare even more important.

Last week the Fed announced two non-traditional programs through which it intends to support the credit markets for consumer loans. Under the first, it will purchase up to $100 billion of the direct obligations of housing-related, government-sponsored enterprises, such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, along with up to $500 billion of mortgage-backed securities backed by Fannie Mae, Freddie Mac and Ginnie Mae. Under the second, it will lend up to $200 billion to holders of certain AAA rated, asset-backed securities backed by new and recently originated consumer and small business loans.

The creation of these programs was foreshadowed in the 2002 speech. Among the roster of possible policy initiatives available to the central bank under a program of so-called quantitative easing, Bernanke listed: 1.) the expansion of the scale of its asset purchases, or the possible expansion of the menu of assets that it buys, 2.) making low interest loans to banks, 3.) engineering lower interest rates further out along the Treasury yield curve by committing to maintaining the overnight rate at zero for a specified period, or by announcing ceilings on specific maturity interest rates and supporting them through open market purchases, 4.) conducting a similar operation in the market for mortgage-backed securities, 5.) offering fixed-term loans to banks at low or zero interest and accepting a wide range of securities eligible as collateral, 6.) in essence printing money to finance fiscal policy initiatives such as tax cuts or stimulus spending, and 7.) intervening to drive the dollar lower.

As observers of the Fed's actions over the last twelve months will note, last week's policy announcements were not first on the roster of non-traditional initiatives to be enacted in response to the credit crisis. As Bernanke noted in his 2002 speech, the best defense against deflation is preventing it from happening in the first place. In saying that, he cautioned that one of the problems with non-traditional policy initiatives is that they are "less familiar, [and] may raise practical problems of implementation and of calibration of their likely economic effects."