Deflation and Liquidity Trap. The Solution.

Paul McCulley, PIMCO wrote an interesting article that reminded us of the risk of deflation, Japan-styled. Often, this risk is the result of politics when government officials withdraw the stimulus prematurely to appease the people. Today, this pressure is already building with everyone pre-occupied with the Fed's bloated balance sheet and the Treasury's huge budget deficit.

For those with monetarist roots, this excess money supply must surely be the classic brew for inflation. For others, this current policy brew is a deflationary force, as the huge deficits would provoke foreign investors to flee from both the USD and Treasuries, driving up interest rates. Indeed, the current brew of policies seemed to please no one. Yet, everyone knows there are no other choices, given the state of the consumer and the negative wealth effect on the economy.

As a result, everyone goes along with the policy brew grudgingly... complaining about it every now and then, and hedging ourselves by saying the Government has to have an exit plan and be fiscally responsible. But here lies a problem.

In 1998, Paul Krugman in the context of the Liquidity Trap, warned that if the public believes that the central bank will exit the printing of money ie. no inflation, then the printed money will simply be hoarded as the deflationary expectations remain entrenched. Hence, to be effective, Mr Krugman said central banks must "credibly promise to be irresponsible" to permit inflation to occur. To get out of the trap (deflation), Krugman said central banks needed to radically change expectations. Quite a radical!

In 2003, Bernanke made comments to the same effects. Essentially, his recipe to get out of deflation is price level targetting. This is more stringent than inflation targetting, as inflation target "forgives" past deflation. This would imply that after a period of deflation, Bernanke would actually allow inflation to be higher and exceed the desired long term rate, to close the price-level gap. This is the reflationary stage. But do central banks and government have the will to do this, knowing that they could come under heavy criticism if expecations swung to the other inflationary extreme? Hence, it was on this point, that Bernanke once remarked that the Fed should subordinate itself to the fiscal authority. Quite a radical too!

Fortunately, we are not quite there yet. The US consumer and stock markets have surprised me and they seemed embarked on a self healing process. Still, it bears watching. The antidote for deflation can be radical.