One fascinating aspect of Ben Bernanke's response to the financial crisis is that everything he's done since it started in 2007, every measure he's taken, every new policy he's enacted have been pre-announced loud, clear and with maximum transparency in a talk he gave on November 21, 2002 at the National Economic Club in Washington titled Deflation: Making Sure "It" Doesn't Happen Here. It is highly recommended reading to anyone wanting to make sense of the "game" the Fed is engaged in.
Back in 2002, Bernanke wanted to assure the public that, should deflation become a problem in the course of what turned out to be the mild 2001-2002 recession, the Fed had a comprehensive playbook to defeat it with increasingly radical and potent measures as the deflationary threat became more urgent. The irony is that none of the most extreme non-conventional means he described in that seminal presentation were needed during the 2001-2002 slump. Cutting the Fed Funds rate to 1% and keeping it there for a (too) long period of time was sufficient to get the economy going again. However, those radical steps are definitely needed now. Bernanke has been running down his own list of things to do to revive the economy and he has been administering increasingly potent elixirs (to use his own term) to an increasingly sickly economy.
I'm not going to list in detail all the plays he ran up to now. For that, you'll have to read the speech transcript. Suffice it to say that he's been uncannily faithful to the playbook: rates have been cut dramatically, are now basically at zero and will be there for the foreseeable future. The Fed started buying agency mortgage-backed and asset-backed securities. And last Wednesday, he reached the part in the playbook where the Fed engages in massive buying of agency securities and long-dated Treasuries. So what's the next play, the next level of non-conventional measures? Well, in Bernanke's own words, this is what needs to be done next (emphasis added):
"The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.
Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation."
As I understand it, this is a pretty straightforward, if couched in diplomatic terms, endorsement of a dollar devaluation policy. One might argue that such a policy had already been used covertly between 2002 and 2008, a period that saw a 42% fall in the dollar index. Whether that devaluation was market-driven or engineered by the Fed and the Treasury (or a combination of the two) is really beside the point. What's certain is that the safe-haven dollar rally (of around 30%) we've been in since August 2008 can't have made Bernanke very happy and will most likely end soon if it hasn't ended already. As a matter of fact, we might have witnessed the end of that rally this past week. Who would want to be long the dollar when the Fed might announce at any moment that they will start buying foreign securities with the specific intent to weaken the currency?
By the way, that's exactly what the Swiss National Bank did on March 12. Their explicitly declared goal? To weaken the Swiss franc.
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