Can Central Banks Prevent Deflation?

Can Central Banks lift the global economy out of an era of potential future deflation? The U.S. Federal Reserve may not have helped during the Great Depression. During the 1945-1973 era there was tremendous growth from the WWII victory which gave the U.S. a massive advantage in trade, gold, monetary policy, etc. and this was source of growth rather than Fed rate cuts. During the inflationary 1970’s the Fed failed to prevent inflation and certainly wasn’t needed to get out of deflation. In the 1980’s tax cuts provided stimulus to get out of recession. So when did the Federal Reserve actually make a difference in terms of stimulating to get out of a recession? (They did make a difference during the 1979-86 rule of Volcker in terms of reducing inflation, but that is the opposite of trying to stimulate).

It may be that the Fed’s near zero rate policies helped stimulate the economy in 2002 by creating a housing bubble and this got the economy out of the recession of 2002 but that was a very light recession. The main reason low interest rates helped the economy in 2002-2004 was because loan underwriting and rating agencies rating of bonds was insanely too lenient and this allowed borrowers to use low rates to overconsume, which merely moved the problem of a mild recession further into the future where it ended up creating a much worse crash in 2008 in the mortgage and real estate industries. If the Fed and other regulatory entities had been managing things properly then the 2002-2008 housing bubble wouldn’t have occurred and the economy would be better off today than it now is.
   Other countries such as Japan and the EU zone have not been able to achieve stimulation through zero rate policy or Quantitative Easing.

Is it possible that the global economy has had undue faith in Central Banks since the Federal Reserve was founded in 1913? Is the world about to enter a true real world “stress test” to see if Central banks can stimulate the economy without help from fiscal policy?
  Perhaps the Invisible Hand of the markets is making global bond yields lower in anticipation that Central Banking monetary policy may not have the answer, at least not if the economy has too much debt, especially when excessive debt means that distressed borrowers can’t qualify to refinance into lower rate loans. Ultimately Central Banking requires an act of faith by consumers and the public to accept fiat money and to accept that a manipulation of the economy won’t quickly revert back to a previous scenario with no net gain for the economy. By that I mean if Central Banking is designed motivate people into anticipating a rising economy and rising inflation and thus induce demand for goods then there may be a point where people simply refuse to believe in the intended policies and thus refuse to be persuaded by QE and Zero rate policies to increase demand.

Too many investors and economists have too much faith that the Fed can magically create inflation or prevent deflation. The consensus was wrong regarding the fear that QE would create CPI inflation; instead the funds stayed inside the portfolios of passive rich investors who didn’t use the proceeds of bonds sales to buy consumer goods (except for pseudo-investment luxury collectables like elite homes, rare art, etc.). As more people lose faith in the Fed’s ability to reflate demand then the marketplace will adjust asset prices towards a more deflationary outlook, implying that interest rates and risk-on asset prices may go down.

Investors need independent financial advice about the risks that Federal Reserve policy won’t help investors. I wrote an article “How much affect did Quantitative Easing really have?”

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Don Martin

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