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The Fed's Punch Bowl Problem

Jeremy Glaser

Jeremy Glaser: From, I'm Jeremy Glaser. I am here today at the 2010 Morningstar Stocks Forum. I am pleased to be joined with Randy Kroszner, who is a former governor of the Federal Reserve, and is now an economics professor at the Chicago Booth School of Business.

Randy, thanks so much for taking the time today.

Randy Kroszner: Delighted.

Glaser: So, Ben Bernanke finally opened up his toolbox and said that he's going to be bringing out $600 billion of new bond purchases, or quantitative easing, that we've been talking about for so long. Why is the Fed making this move?

Kroszner: I think, it's really important that they are to really buy some insurance against a very bad outcome, that outcome being deflation. You can get into a situation, like we got in the 1930s, or that Japan has gotten into, that if you actually have the price levels start to fall, you have very big debt burdens on people, you have people waiting to make purchases because they see prices are going to go down in the future. You get into a very difficult deflation spiral, hard to get out of it. So I think, it's very important that the Fed is trying to provide some support right now.

Glaser: This is something they've been talking about for a long time. Do you think it's going to be effective?

Kroszner: I think, it's already been effective. What I sometimes call the types of things that they're doing are open-mouth operations, rather than open-market operations, because they're trying to affect expectations, but what the Fed will do, is it really committed to fighting deflation? This is one of the problems with the Bank of Japan. They are very slow to respond to the declining inflation rate, and even when they got to deflation, they were still very slow to respond, and once you get stuck down there it's hard to get out. The Fed is trying to be proactive, make sure we don't get into that situation, and I think that's really valuable.

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Glaser: So it's certainly something valuable they're doing. But are they going to be able to exit out of this position?

Kroszner: Well, that's one of the challenges going forward. What they're really trying to do is make sure that inflation expectations don't fall too low down to deflation. They're trying to boost up inflation expectations a little.

It's very difficult to just boost them a little bit. You can either make mistakes like Japan did and allow them to go down, or like many central banks in the past have had very, very high inflation and so the expectations go up.

I think, if any central bank can do this, it's the Bernanke Fed, but it's going to be very, very difficult, let's say, a year from now, if the unemployment rate is still high, as it's likely to be, let's say, they're successful in fighting the deflation, and we're starting to get inflation come back up. Will they be able to remove the punch-bowl fast enough? Not certain about that. I think, they have a good plan in place to try to do that, but will they be able to do it quickly enough, there are real challenges.

Glaser: Congress certainly looks like it's going to be deadlocked for the next two years, difficult to get things done, so a lot of--any stimulus that's going to come out of the federal government, it's going to come from the Federal Reserve, is that a position that they're comfortable taking, is it something they are going to be able to do, or does Congress really need to act as well?

Kroszner: Well, I think that's one of the things the Fed knows that there is no more stimulus money coming, but I'm also not so sure how effective the original stimulus spending was. One of the things it could be very contractionary, though, and the real problem is if tax rates go up really dramatically. This happened in 1937 and the economy that had been recovering from the early Great Depression went back down. We don't want to have that happen, and if Congress can't get along with the administration, they can't get an agreement, we could have a sharp increase in taxes and that could put a very fragile economic recovery back down in the tank, unfortunately.

Glaser: Sounds like we still live in a world of great uncertainty.

Do you have any advice to investors about what asset classes they should be thinking about, or how they should position their portfolios?

Kroszner: Well, I think, it really depends on what weight you put on these different scenarios. So let's say, you don't believe that the Fed can actually fight the deflation, so we get into a deflationary scenario. Typically what you'd want to do in that circumstance is hold very, very high-quality debt, because many firms were defaulting because the price level is going down, the prices that they are paid for their products is going down, but they still have nominal debt of $1,000 or $10,000.

Also, you might want to think about staying in the dollar, because as we can see from the example of Japan, a long-term deflation can be positive for your currency, even if it's really devastating for your economy.

A second scenario is the possibility that the Fed kind of gets it right, which is, I think, where I would put most of the weight, but I'd still be hedging my bets a little bit. So that they fight the deflation, we start to get a reasonable recovery, at least over the next year or two. And what we've seen already is just the announcement of this program having a very positive impact on equity prices. And I'll remind you that when the Fed finally got its act together in the early 1930s, it had missed the boat, allowed deflation to occur, but changed monetary policy doing something like quantitative easing. They started that in 1933. 1934 was one of the best years of the stock market of the 20th century.

But if you're very concerned that the Fed is not going to get this right, we're going to have too much inflation fairly soon, then of course, you're going to be very wary of being in bonds, because interest rates will go up, the stock market typically has not performed particularly well during high inflation periods, think back to the 1970s, so something like Treasury Inflation Protected Securities might be the way to go.

Glaser: Sounds like some great advice for investors. Randy, thanks so much for talking with me today.

Kroszner: Thank you very much.

Glaser: For, I'm Jeremy Glaser.