Expansive monetary policy, i.e., the zero interest rate policies the Fed is now pursuing, contrary to all the Helicopter Bernanke’s of the world, can cause deflation, the exact opposite of their intent. 

How so?  It’s somewhat complicated, but lest there be any doubt whether it’s possible, just look across the pond at Japan’s economic performance over the course of the last two decades.   

The process works something like this:  Prices wish to fall, but low interest rates initially spur inflation, or at least stable prices that would otherwise have fallen, but for the expansive monetary policy.  Prices for all sorts of goods naturally trend downward over time for a number of reasons–technological advancements, production efficiencies, oversupply, cost reductions and the maturation of markets, among others.   Expansive monetary policy can mask and forestall the tendency for prices to decline, but only for the short run. 

If monetary policy prevents prices from falling that would otherwise do so, it creates an illusion of demand which spurs an expansion in production when production should actually be curtailed (the prescription for oversupply).  Eventually the oversupply becomes too great to bear the weight of the monetary shenanigans and demand collapses, taking prices with it.  This happens regardless of how much oversupply of money has been created through the expansive monetary regime.   In the meantime, extra money gets poured into assets, like housing and the stock market, that don’t seem as susceptible to illusory demand.  Or, it does until it is realized that they suffer as well from distorted price signals, perhaps even more so than regular consumer goods. 

This scenario describes the US economy since at least 9/11, probably well before.  Expansive monetary policy created the illusion of expanded demand in consumer goods and services.  Production expanded, either domestically or overseas, to meet this illusory demand.  Excess money created by the expansive monetary policy poured into assets–first the stock markets (before 2000) and then housing, fueling massive inflations that didn’t show up in the measurements of consumer goods and services, which showed relatively benign inflation, or none at all.  Deflation in consumer goods is what the expansive monetary policy was intended to prevent.

But the failure of prices to decline when they otherwise should because of expansive monetary policy is as much inflation as is an outright increase in prices, and the failure of prices to decline when they should causes oversupply, which can only be remedied by–you guessed it–declining prices.

Thus the Fed’s zero interest rate policy is apt to do exactly the opposite of what it intends.  It will likely cause rather than prevent deflation.

Incidentally, money will become much cheaper to rent as well during this post-inflationary deflation, as my post on zero interest rate financing for housing makes clear.  When there are too many things–houses, cars, refrigerators–for innate demand to support, money prices decline, too.  Nobody needs money for either buying or making stuff that is oversupplied and overbought.  Money velocity drops to nil, along with the rent (interest rates) charged for its use.

James Bullard, President of the St. Louis Federal Reserve Bank, somewhat shares this view–that a zero interest rate policy can cause, instead of prevent, deflation, but for different reasons than I’ve explained here.   His prescription for this interest rate induced deflation is for the Fed to do some more quantitative easing.  Ugh!  There is no evidence that two decades of QE in Japan have done anything to get prices out of the doldrums.  The long-term problem in Japan is collapsing demand due to demographic forces, which all the Yen printing in the world won’t solve.  Velocity will go down faster than Yen can roll off the presses.

Unfortunately, however, the idea that a zero interest rate policy could cause deflation is anathema to the central dogma of the monetarist theorists ruling the Fed that believe simple manipulations of the money can yield real, sustainable changes in the forces driving economic performance.  Bernanke is likely soon to learn that all the helicopter’s in the world can’t stop prices and economies from crashing in the face of massively oversupplied demand–which ironically got that way because of distorted price signals attendant to the same expansive monetary policy that it is believed will fix them.

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