In November 2002, prior to becoming Fed Chairman, Ben Bernanke gave an infamous speech titled Deflation: Making Sure "It" Doesn't Happen Here that got gold bugs all over the world atwitter and led to the moniker 'Helicopter Ben.' I remember reading this speech and thinking that Heli Ben would be a worthy successor to Easy Al Greenspan. And he has indeed turned out to be as committed to Keynes and loose money as his predecessor was.
Overall, this is one of the most important speeches in Fed history since it laid out the template for how the Fed would battle a deflationary shock to the system. Bernanke actually followed through on many of his prescriptions by exploding the Fed’s balance sheet, buying non-Treasury collateral, engaging in QE, opening the discount window to banks, and through Operation Twist in 2011. The Fed hasn’t explicitly set a ceiling for long-term rates yet, but that may also follow should we see long-term yields spike to a level Ben deems uncomfortable (which eventually will be anything over 2%).
Bernanke saw the chances of deflation in the US as slim given the “remarkable” resilience and structure of the economy, and the potential actions the Fed could take (he would also see the subprime bubble as "contained" years later). However, in the event that deflation did occur, he saw the Fed’s price stability mandate as covering not just inflation but “definitely” deflation as well.
In his speech, Bernanke covered both measures for preventing deflation and also measures for fighting deflation if prevention efforts failed and deflation started to take hold. Measures for preventing deflation included having a buffer for the inflation rate (i.e. not trying to push inflation to zero during “normal“ times), being vigilant in protecting the financial system (fighting fire sales of assets, using the discount window), and being proactive and aggressive in cutting rates if the economy weakened suddenly.
More interesting are the measure he outlined for “curing” deflation. When nominal interest rates hit the zero bound, traditional ways of stimulating demand do not work, but deflation is still reversible by the following means:
1. Printing Money
“… the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
2. Expanding the scale of asset purchases as well as the menu of assets bought (a prescription that he followed to a ‘T’ in 2008/09 by massively increasing the Fed’s balance sheet to over $2T and buying non-Treasury collateral)
3. Bringing down long-term interest rates to stimulate spending by (1) committing to holding the short-term rates at 0 for a specified period or (2) by announcing explicit ceilings for yields on longer-maturity Treasury debt, or (3) buying agency debt. He also noted that explicitly setting ceilings had been done before: the Fed enforced a 2.5% ceiling on long-term bond yields for nearly a decade in the 1950s (as well as ceilings on 90 day and 12 month T-Bills).
4. Influencing the yields on private securities by lending to banks through the discount window and accepting a wide range of private assets (corporate bonds, CP, bank loans, and mortgages) as collateral [which he did during the financial crisis].
5. Intervening to target the value of the dollar (for example, FDR’s 40 percent devaluation of the dollar against gold in 1933-34).
6. Coordinating fiscal and monetary policy actions
a. Tax cuts coupled with open market purchases which would keep rates low but increase consumption.
b. Targeting asset values to lower the cost of capital and improve the balance sheet of borrowers.
c. Increasing government spending (class Keynesian stimulus that would warm Paul Krugman’s heart)
Bernanke also analyzed deflation in Japan and pointed out reasons why deflation had taken hold there: the problem with the financial sector (zombie banks) , the overhang of large government debt, and, most importantly, because of political deadlock in dealing with the situation.
Bernanke hinted at the importance of asset values to consumer balance sheets in his speech, and he expanded on some of those themes in an important op-ed in the Washington Post on November 4, 2010 (What the Fed did and why: supporting the recovery and sustaining price stability). In this op-ed he unofficially added a third leg to the Fed’s dual mandate of price stability and low unemployment: higher asset prices.
“… higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
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