35 Trillion Reasons II
Part II - The US Situation
In 2002, the United States faced the threat of deflation for the first time since the Great Depression. Growing trade imbalances and a surge in the global money supply had contributed to the credit excesses of the late 1990s and resulted in the New Paradigm technology bubble.
That bubble popped in 2000 and was followed by a serious global economic slowdown in 2001. Policy makers in the United States grew increasingly alarmed that deflation, which had taken hold in Japan, China and Taiwan, would soon spread to America.
Deflation is a central bank's worst nightmare. When prices begin to fall, interest rates follow them down. Once interest rates fall to zero, as is the case in Japan at present, central banks become powerless to provide any further stimulus to the economy through conventional means and monetary policy becomes powerless.
The extent of the US Federal Reserve's concern over the threat of deflation is demonstrated in Fed staff research papers and the speeches delivered by Fed governors at that time.
For example, in June 2002, the Board of Governors of the Federal Reserve System published a Discussion Paper entitled, "Preventing Deflation: Lessons from Japan's Experience in the 1990s."
The abstract of that paper concluded "...we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus-both monetary and fiscal- should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity."
From the perspective of mid-2002, the question confronting those in charge of preventing deflation must have been how far beyond the conventional levels implied by the base case could the economic policy response go?
The government budget had already swung back into a large deficit and the Federal Funds rate was at a 41 year low. How much additional stimulus could be provided?
A further increase in the budget deficit seemed likely to push up market determined interest rates, causing mortgage rates to rise and property prices to fall, which would have reduced aggregate demand that much more. And, with the Federal Funds rate at 1.75% in mid- 2002, there was limited scope left to lower it further.
Moreover, given the already very low level of interest rates, there was reason to doubt that a further rate reduction would make any difference anyway. In Part III we will examine the Fed's influence.
In 2002, the United States faced the threat of deflation for the first time since the Great Depression. Growing trade imbalances and a surge in the global money supply had contributed to the credit excesses of the late 1990s and resulted in the New Paradigm technology bubble.
That bubble popped in 2000 and was followed by a serious global economic slowdown in 2001. Policy makers in the United States grew increasingly alarmed that deflation, which had taken hold in Japan, China and Taiwan, would soon spread to America.
Deflation is a central bank's worst nightmare. When prices begin to fall, interest rates follow them down. Once interest rates fall to zero, as is the case in Japan at present, central banks become powerless to provide any further stimulus to the economy through conventional means and monetary policy becomes powerless.
The extent of the US Federal Reserve's concern over the threat of deflation is demonstrated in Fed staff research papers and the speeches delivered by Fed governors at that time.
For example, in June 2002, the Board of Governors of the Federal Reserve System published a Discussion Paper entitled, "Preventing Deflation: Lessons from Japan's Experience in the 1990s."
The abstract of that paper concluded "...we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus-both monetary and fiscal- should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity."
From the perspective of mid-2002, the question confronting those in charge of preventing deflation must have been how far beyond the conventional levels implied by the base case could the economic policy response go?
The government budget had already swung back into a large deficit and the Federal Funds rate was at a 41 year low. How much additional stimulus could be provided?
A further increase in the budget deficit seemed likely to push up market determined interest rates, causing mortgage rates to rise and property prices to fall, which would have reduced aggregate demand that much more. And, with the Federal Funds rate at 1.75% in mid- 2002, there was limited scope left to lower it further.
Moreover, given the already very low level of interest rates, there was reason to doubt that a further rate reduction would make any difference anyway. In Part III we will examine the Fed's influence.
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