By: Scott Van Den Berg, CFP®, ChFC®, CEPA®, AIF®, CRPS®, CMFC®, AWMA®
This deflation question is one we have received more and more and therefore have addressed it in the following commentary.
On May 28, 2020, the U.S. Bureau of Economic Analysis reported that the U.S. economy declined 5% during the first quarter, as measured by gross domestic product (GDP). This, in our opinion, was a direct reflection of the measures taken to slow the spread of COVID-19. When federal, state, and local governments issued "stay-at-home" orders in March, businesses and schools transitioned to remote work or were forced to cancel operations, and consumers canceled, restricted, or redirected their spending. This, in turn, led to a rapid decline in the demand of many goods and services.
There are signs an economic recovery is in the early stages. However, the U.S. unemployment rate is approaching 20%, the rate and shape of the recovery is still up for debate, and at the very least, it seems reasonable to assume that some parts of the economy will likely recover faster than others. If COVID-19 picks up again later in the year or other unforeseen circumstances cause the economy to continue to contract, could we see deflation?
Deflation, should it occur, would be a significant problem. During deflation, the value of assets, such as homes and businesses, would likely decline. Yet those who have outstanding debt on those declining assets would still need to pay that debt. At some point, the debt owed could become greater than the underlying asset. You may recall that in 2008, many home values went below mortgage values causing a spike in foreclosures, and many business values went below their debt levels forcing many to file for bankruptcy. This is why we must avoid deflation.
We believe Ben Bernanke, former Chairman of the Federal Reserve, effectively argued that the Fed can easily win the fight against deflation in his November 21, 2002 speech, Deflation: Making Sure “It” Doesn’t’ Happen Here. (Click on the link to read the entire speech.)
In this speech before the National Economists Club in Washington, D.C. he stated that, “The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress."
Chairman Bernanke further emphasized that Congress gave the Fed responsibility for preserving price stability (among other objectives), which implies avoiding deflation as well as inflation. He stated that deflation is always reversible under a fiat money system. That is to say, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve monetary policy goals). Most importantly, Chairman Bernanke asserted that the Fed "has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief".
To combat deflation, Bernanke provided a prescription for the Federal Reserve to prevent it. He identified seven specific measures that the Fed can use to prevent deflation:
1. Increase the money supply (M1 and M2).
“The US government has a technology, called a printing press that allows it to produce as many dollars as it wishes at essentially no cost." "Under a paper-money system, a determined government can always generate higher spending and, hence, positive inflation.”
2. Ensure liquidity makes its way into the financial system through a variety of measures.
“The U.S. government is not going to print money and distribute it willy-nilly ...”although there are policies that approximate this behavior.”
3. Lower interest rates – all the way down to 0 per cent.
Chairman Bernanke observed that people have traditionally thought that, when the fed funds rate hits zero, the Federal Reserve will have run out of ammunition. However, by imposing yields paid by long-term Treasury Bonds, “a central bank should always be able to generate inflation, even when the short-term nominal interest rate is zero ...this more direct method, which I personally prefer, would be for the Fed to announce ceilings for yields on all longer-maturity Treasury debt.”
“Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation.” He also noted that the Fed had successfully engaged in "bond-price pegging" following the Second World War.
4. Control the yield on corporate bonds and other privately issued securities.
Although the Federal Reserve cannot legally buy these securities (thereby determining the yields), it can simulate the necessary authority by lending dollars to banks at a fixed term of 0 per cent, taking back from the banks corporate bonds as collateral.
5. Depreciate the U.S. dollar.
Referring to U.S. Monetary Policy in the 1930s, under President Franklin Delano Roosevelt, he states that:
“Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34 was 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”.
6. Execute a de facto depreciation by buying foreign currencies on a massive scale.
“The Fed has the authority to buy foreign government debt ... this class of assets offers huge scope for Fed operations because the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.”
7. Buy industries throughout the U.S. economy with "newly created money".
In essence, the Federal Reserve acquires equity stakes in banks and financial institutions. In this "private-asset option," the Treasury could issue trillions in debt and the Fed would acquire it, still using newly created money.
At the end of the day, we believe the Fed’s effort to keep the economy going may cause them to eventually over-do-it as they continue to increase our country’s debt levels and get into the business of buying assets. While we believe they will successfully fight-off deflation, as a result, we believe it will eventually lead to higher rates of inflation.
From an investment and wealth management perspective, we believe we can address deflation and inflation with the following process:
- Hold some cash for opportunities that will likely present themselves.
- Hold a small percentage of assets in gold to hedge against a declining dollar and inflation.
- Recommend individuals and households remain as debt free as possible.
- Favor securities that have pricing power, high cash levels, low debt levels, and that generate free cash flow.
Disclosures: The information provided in this discussion should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that the information discussed was or will prove to be profitable. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness.