Tuesday, December 9, 2008

The dangers of deflation can be scary not to mention Inflation

The Federal Reserve Chairman Ben Bernanke seems to have his hands full lately.
When asked about  General Motors Corp., Ford Motor Co. and Chrysler LLC Bernanke said that Congress should consider a “range of possible policy actions” besides direct aid, including a government-assisted “orderly bankruptcy reorganization” or company mergers. 

General Motors Corp., Ford Motor Co. and Chrysler LLC have asked U.S. lawmakers for as much as $34 billion in aid. Congress is discussing a $15 billion rescue proposal where the Treasury would get warrants for stock equivalent to 20 percent of any government loans.  Stock warrants are issued so that the warrant holder has the option to buy stock at a particular price.

 “Even if the companies have sufficient collateral, lending to an auto manufacturing company would represent a marked departure from that policy, and would take us into distinctly new realms of policymaking,” Bernanke said.  He also said that, “the Federal Reserve would be extremely reluctant to extend credit where Congress has actively considered providing assistance but, after due consideration, has decided not to act.” [1]

As default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.  Whitney, an analyst and managing director at Oppenheimer & Co. who predicted the current financial-services industry meltdown, now says credit-card issuers will eliminate more than $2 trillion in available credit over the next 18 months. [2]

Pumping up the money supply should melt a credit freeze. The Fed chairman faces huge obstacles in trying to restart the credit engine and get maxed out consumers spending again.  Given the scale of the Fed's interventions, it should be weakening the value of the dollar and setting us on a course toward inflation.  Inflation happens when prices rise. Deflation happens when they fall. In this December's dark economy, falling prices for gasoline, cars, and clothes and just about anything would seem like a silver lining.

Federal Reserve Chairman Ben Bernanke and his colleagues are clearly more concerned with the risk of a deflationary spiral than with inflation right now.  But deflation can be scary. Buyers assume everything will be cheaper in the future, so they wait for bargains. If no one is buying, factories curb production. Workers lose their jobs and shops close.

“The federal funds rate is trading persistently below target,” said Poole, who is a contributor to Bloomberg News. “That can’t be an accident. I personally do not believe the Fed should tie asset purchases to any specific fiscal programs, whatever their merits,” Jeffrey M. Lacker President of the Federal Reserve Bank of Richmond said after a speech in Charlotte, North Carolina, Dec. 3. At the same time, he said he was open to purchasing U.S. government debt for the purpose of fighting the danger of deflation.  

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