Why the Fed Cannot Stop Deflation
Countless people say that deflation is impossible because the Federal Reserve Bank can just print money to stave off deflation. If the Fed’s main jobs were simply establishing new checking accounts and grinding out banknotes, that’s what it might do. But in terms of volume, that has not been the Fed’s primary function, which for 89 years has been in fact to foster the expansion of credit. Printed fiat currency depends almost entirely upon the whims of the issuer, but credit is another matter entirely.
What the Fed does is to set or influence certain very short-term interbank loan rates. It sets the discount rate, which is the Fed’s nominal near-term lending rate to banks. This action is primarily a “signal” of the Fed’s posture because banks almost never borrow from the Fed, as doing so implies desperation. (Whether they will do so more in coming years under duress is another question.) More actively, the Fed buys and sells overnight “repurchase agreements,” which are collateralized loans among banks and dealers, to defend its chosen rate, called the “federal funds” rate. In stable times, the lower the rate at which banks can borrow short-term funds, the lower the rate at which they can offer long-term loans to the public. Thus, though the Fed undertakes its operations to influence bank borrowing, its ultimate goal is to influence public borrowing from banks. Observe that the Fed makes bank credit more available or less available to two sets of willing borrowers.
During social-mood uptrends, this strategy appears to work, because the borrowers — i.e., banks and their customers — are confident, eager participants in the process. During monetary crises, the Fed’s attempts to target interest rates don’t appear to work because…
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