(Dislaimer: I am not an economist).
Normally, when an economic slowdown is taking place the Federal Reserve lowers interest rates, the economy responds, and what the severity of the slowdown seems to be eased. In August of 2007 the Fed began a series of rate cuts as the "subprime" problem started to spread. The market responded, reversing a 10% correction off it's highs and resuming a rally that by late October brought it to a new high. It started into another correction, and on October 31, the Fed reduced rates again, this time sending the market plunging into the bear market we are now in.
So, why didn't it work?
The U.S. Dollar index had been in a downtrend for much of the bull market of 2003 to 2007, but in August of 2007 went into a near free fall, which was stopped right about the time of the Bear Stearns failure. It seemed to stablize, then in about mid-July, about the time of the Indymac Bank failure, it started rising rapidly (it was at this time that commodity prices topped and began a crash). After a brief pullback, it shot up again with the failures of Lehman, Merrill, AIG, Fannie Mae, and Freddie Mac impending. It continued to rise until October, coinciding with the stock market crash. Since then it has pulled back again, and after a bounce, appears ready to head down again. During the last few months, "deflation" is being used to describe what has been happening. So, what the heck is "deflation"?
It seems that none other than Ben Bernanke, in 2002, gave a speech on that very subject. First, he gives a very good definiton of what deflation is:
"Deflation is defined as a general decline in prices, with emphasis on the word "general." At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declinesa re so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines."
So deflation is a rise in the buying power of money because prices overall are dropping.
"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."
A "collapse" in demand, caused by what? Perhaps a panic in the financial system?
"However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero.2 Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound." "
Here we are getting to something. It seems that the response to a "normal" recession, lowering interest rates, are inneffective in a deflationary recession, because borrowers are unwilling to borrow money that has to be paid back in dollars that are increasing in value.
That sounds pretty nasty. Could it have been prevented?
"The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place."
Ok, the rate cuts didn't work. Now what?
"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. "
The "helicopter drop".
"So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities"
This is exactly what we are seeing. The collapse of the $TNX and $TYX have no other explanations. Mr. Bernanke seems to be a pretty smart guy. Let's hope he knows what he is doing, because I'm getting the feeling he is playing a game of economic "chicken" with our childrens' futures.
Be sure to read the entire speech, it is quite enlightening.
Charts courtesy of stockcharts.com