Preprint Federal Reserve Bank of St. Louis September-October Issue 2010

July 29, 2010

After reading James Bullard's twenty-three page paper on possible monetary responses to further economic shocks, we feel it is important for investors to gain a basic understanding of how future Fed policy could impact the value of an individual's savings and other financial assets. The basic premise of Mr. Bullard's work is as follows:

• Current Fed policy keeping interest rates low for an extended period may be causing the economy to fall into an undesirable steady state of low nominal interest rates and low inflation expectations.

• This undesirable steady state is similar to what sparked Japan's lost decade.

• Current Fed policy reinforces a low expectation of future inflation, which in turn helps keep inflation at bay as market participants feel no compelling reason to take actions in preparation for future inflation. These actions might include investing, buying hard assets, or taking out a loan before interest rates go up.

• Keeping rates low for an extended period also creates a perception that "things must be bad; therefore, it is not a good time to hire, expand, or take risk".

• If there is no credible reason to believe policy or inflation rates are about to change, there is no impending event to prepare for future inflation.

• Rising inflation expectations can become a self-fulfilling prophecy as market participants begin to prepare for a future with higher inflation and higher interest rates.

• The best way to shock market participants out of the undesirable steady state is to begin a program of quantitative easing, where the Fed purchases U.S. Treasuries.

• In order for quantitative easing to sufficiently increase future inflation expectations, market participants must believe the Fed will do "whatever it takes for as long as necessary" to obtain the objective of sufficiently positive inflation. This means the Fed must be willing to leave balance sheet expansion in place for as long as necessary to create expectations of higher future inflation by market participants (consumers, investors, companies, etc.). This remainds us of past "bazooka-like" policy moves, where policymakers would say, "You think we can't create positive inflation? Just watch."

What could all this mean to me and my investments?

Let's start with quantitative easing, where the Federal Reserve buys Treasury bonds. Using a hypothetical example to illustrate the basic concepts, assume a typical American citizen has some Treasury Bond certificates in a shoebox under their bed. If the Fed offers to buy those bonds, they will be exchanging paper money, not currently in circulation, for a bond certificate. After the transaction, the American citizen has newly printed money and the Fed now has a bond certificate. It is easy to see in this example the Fed has increased the money supply by buying the bonds. The Treasury Bond represents an IOU from the U.S. Government. When the Fed buys bonds in the open market, it is like the government buying back its own IOU with newly created money. This is about as close to pure money printing as it gets.

How is this policy any different from lowering interest rates or increasing bank reserves?

Lowering interest rates and flooding the banking system with cash has one major drawback; if the banks won't issue loans or customers do not want to take out loans, the low rates and excess bank reserves do little to expand the supply of money in the real economy. Therefore, these policies can fall into the "pushing on a rope" category. Quantitative easing, or Fed purchases of Treasury bonds, injects cash directly into the real economy, which is a significant difference.

How could all this create inflation and why should I care?

In a simple hypothetical example, assume we could keep the amount of goods and services available in the economy constant for one year. During that year, the Fed buys enough Treasuries to exactly double the dollar bills in circulation. The laws of supply and demand say if we hold supply constant (goods and services) and double demand (dollars chasing those good and services), prices will theoretically double. Obviously, if the prices of all goods and services doubled, the purchasing power of your current dollars in hand would be cut in half. This is known as purchasing power risk.

If the Fed starts buying bonds what could happen?

Since the Fed would be devaluing the paper currency in circulation, market participants would most likely wish to store their wealth in other assets, such as gold, silver, oil, copper, stocks, real estate, etc. The mere announcement of such a program would begin to accomplish the Fed's objective of creating an expectation of higher future inflation. The expectation of future inflation can lead to asset purchases and investing, which in theory creates inflation by driving the prices of goods, services, and assets higher. In fact, the creation of this document and your reading of it assist in the process of creating increased expectations of future inflation, which is exactly what the Fed is trying to accomplish.

Chicken or Egg: Inflation Expectations or Inflation

Mr. Bullard hypothesizes the current economy may need rising inflation expectations to come first, which in turn would help create actual inflation since it would influence the buying and investing habits of both consumers and businesses. If you feel the Fed will "do whatever it takes" to create inflation, you may decide you need to protect yourself from inflation by investing in hard assets, like silver and copper. Your purchases of hard assets would help drive their prices higher. The mere perception of the possible devaluation of a paper currency can change the buying and investing patterns of both consumers and businesses.

Wild Card Makes 945 to 1,010 on S&P 500 Difficult

From a money management perspective, understanding possible Fed actions, especially before high stress and volatile periods arrive, can assist you in making more rationale and well planned decisions. Even prior to the release of Bullard's paper, we hypothesized some possible market scenarios on July 22, 2010 in Bernanke, the Fed, Deflation, and the Dollar. The comments from July 22nd still apply, but it appears now as if the Fed would move directly to an asset purchase program.

How serious is this?

We should stress Mr. Bullard's work relates to contingency plans only. He states a deflationary outcome could occur in the U.S. "within the next several years". In a conference call on Thursday, Bullard said, "This is a matter of being ready in case something else hits. What if there's a terrorist attack? What if there is some kind of trouble in the Asian recovery or something like that?" He added, "The most likely possibility from where we sit today is that the recovery will continue through the fall, inflation will start to move up and this issue will all go away".

Unfortunately, sometimes when an option is given to the markets, it forces the hand of policymakers. This means markets may remain volatile for a time, maybe even long enough to bring about an announcement of quantitative easing from the Fed. We will continue to comment on this topic from time to time in our blog, Short Takes.