FED, ECB, CENTRAL BANKS CUT RATES IN COORDINATED MOVE

     Oct. 8 (Bloomberg) -- The Federal Reserve, European Central

Bank and four other central banks lowered interest rates in an

unprecedented coordinated effort to ease the economic effects of

the worst financial crisis since the Great Depression.

     The Fed, ECB, Bank of England, Bank of Canada and Sweden's

Riksbank each reduced their benchmark rates by half a percentage

point. The Bank of Japan, which didn't participate in the move,

said it supported the action. Switzerland also took part. China's

central bank separately cut its key rate 0.27 percentage point.

     ``We are now looking at the first page of the global-

depression playbook,'' said Carl Weinberg, chief economist at

High Frequency Economics in Valhalla, New York. ``The only

solution is to cut rates as close to zero as you dare,'' pump

money into the banking system ``hand over fist'' and increase

government spending, he said.

     Today's decision follows a global meltdown that sent U.S.

stock indexes heading for their biggest annual decline since

1937; Japan's benchmark today had the worst drop in two decades.

Policy makers are also aiming to unfreeze credit markets after

the premium on the three-month London interbank offered rate over

the Fed's main rate doubled in two weeks to a record.

                            Rate Levels

     The Fed reduced its benchmark rate to 1.5 percent. The ECB's

main rate is now 3.75 percent; Canada's fell to 2.5 percent; the

U.K.'s rate dropped to 4.5 percent; and Sweden's rate declined to

4.25 percent. China cut interest rates for the second time in

three weeks, reducing the main rate to 6.93 percent.

     Stocks at first rallied after the announcement, then turned

lower. Some analysts said the central banks should have lowered

rates by more, and predicted further reductions. Economists at

Goldman Sachs Group Inc. and Morgan Stanley now project another

half-point move by the Fed at its Oct. 28-29 meeting.

     The Standard & Poor's 500 Stock Index fell 1.1 percent to

984.94 at the close in New York, capping a 16 percent loss in six

trading days. Europe's Dow Jones Stoxx 600 Index slumped 6

percent. Japan's Nikkei 225 Stock Average lost 9.4 percent to

9,203.32 earlier today, before the announcement.

     ``The recent intensification of the financial crisis has

augmented the downside risks to growth and thus has diminished

further the upside risks to price stability,'' the central banks

said in a joint statement today. ``Some easing of global monetary

conditions is therefore warranted.''

                          World Recession

     Global policy makers are reducing rates as economies weaken

around the world. The International Monetary Fund said the global

economy is heading for a recession in 2009 and increased its

estimate of losses from the financial crisis to $1.4 trillion.

     The crisis already prompted the U.S. to enact a $700 billion

program to buy troubled assets from banks in an effort to prop

them up. U.K. banks will get a 50 billion-pound ($87 billion)

government bailout, while Spain will spend as much as 50 billion

euros to buy bank assets. European governments have also moved to

rescue banks Fortis, Dexia SA and Hypo Real Estate Holding AG.

     The U.S. Treasury said today it sees ``severe dislocations''

in the government bond market and plans to sell more debt to

address shortages. The market problems ``are across the Treasury

market curve'' and are primarily affecting medium- and long-term

debt, from two-year notes through 30-year bonds, a Treasury

official told reporters.

     The Fed's Open Market Committee, which voted unanimously for

today's move, said in its statement that ``incoming economic data

suggest that the pace of economic activity has slowed markedly in

recent months. Moreover, the intensification of financial-market

turmoil is likely to exert additional restraint on spending.''

                        Europe's Reversal

     European policy makers were forced into action after the

collapse of Lehman Brothers Holdings Inc. last month roiled world

financial markets and caught them off guard. The ECB raised rates

in July and Bank of England Governor Mervyn King warned the

government as recently as Sept. 16 that inflation was set to

accelerate.

     The decision to let Lehman go ``had enormous, very

unfortunate consequences,'' European Central Bank President Jean-

Claude Trichet said Oct. 2. On the same day, he signaled the ECB

was ready to cut rates.

     ECB council member Ewald Nowotny said in an interview that

today's rate reduction ``should not be seen as a first step in a

possible series'' by the ECB. ``The situation has to be assessed

as we go along,'' and the current rate level ``will ensure that

inflation expectations remain anchored,'' said Nowotny, chief of

Austria's central bank.

                      Deteriorating Economy

     Today's action comes a day after Fed Chairman Ben S.

Bernanke failed to assuage investors' concerns about the

deteriorating economy by signaling he was ready to lower

borrowing costs.

     Fed officials, who have kept their benchmark rate at 2

percent since April, may have wanted time for their record loans

to the financial industry and new programs, including purchases

of commercial paper, to bear fruit before lowering rates.

Investors instead perceive the economic outlook deteriorating

more rapidly, necessitating rate reductions.

     The declines in U.S. shares the past two days followed pre-

market opening announcements of fresh actions by the Fed to

unblock credit markets. On Oct. 6, the U.S. central bank doubled

its planned auctions of cash to banks to as much as $900 billion.

Yesterday, it unveiled a unit to buy commercial paper, debt used

by companies for short-term funding.

     Central bankers acted two days before they gather with

finance ministers from the Group of Seven industrial nations in

Washington. The timing suggests the central banks sought to avoid

any appearance of being influenced by governments, said Ted

Truman, former chief of the Fed's international-finance division.

                          `Before Friday'

     ``It was clear that if they wanted to do it, they had to do

it before Friday,'' said Truman, now a senior fellow at the

Peterson Institute for International Economics in Washington.

``they don't want to see as being coordinated by their finance

ministers into doing this.''

     Both U.S. presidential candidates said they backed the Fed's

rate cut. Democrat Barack Obama said more was needed and said he

hoped the global coordinated response to the crisis continued at

the G-7 meeting of finance leaders in Washington this week. Both

he and Republican John McCain said the Fed action had to be

accompanied by further moves to help homeowners.

     Obama has surged in polls in the past three weeks as the

credit freeze worsened and global equity markets plunged, with

respondents saying he would do a better job managing the economy.

An NBC-Wall Street Journal poll conducted Oct. 4-5 found Obama

supported by 49 percent of registered voters, a 6-point margin

over McCain. Two weeks ago an NBC-Journal poll put Obama's lead

at 2 points.

                         Bernanke Message

     Bernanke said in a speech yesterday that an intensifying

credit crunch means officials must ``consider'' lowering

borrowing costs.

     In more typical market conditions, stocks rally when a Fed

chief indicates he'll reduce rates. Now, Bernanke's message may

have less power because traders already anticipated for weeks

that policy makers would need to make that move, and because of

rising concern even rate cuts may do little to immediately help

banks scrambling to reduce their vulnerability to loan losses.

     ``This is an extraordinary circumstance,'' said Former Fed

Governor Laurence Meyer, now vice chairman of Macroeconomic

Advisers LLC. ``If markets are totally frozen it doesn't help. It

certainly builds confidence psychologically.''

By Scott Lanman BLOOMBERG

LYING, CHEATING BANKERS - ECONOMIST

Lying, cheating bankers

Talking about their work makes bankers more dishonest

“IF YOU can only be good at one thing, be good at lying…because if you’re good at lying, you’re good at everything.” Thus a wag imagined one investment banker advising another in a lift. He may not have been far wrong.

In an experiment published by Nature this week, 128 bankers with an average of 12 years’ experience in the industry were split into two groups. The “control” group was asked a series of anodyne questions—for instance, how many hours of television they watched each week. The “treatment” group was quizzed on their work at their bank.

Each banker was then asked to toss a coin in private ten times and report the results. For each toss they could win $20, depending on whether the coin landed on “heads” or “tails”. (If it landed on the wrong side, they got nothing). The bankers reported the results of their ten flips on a computer, and received payment automatically. With enough lucky flips—or shameless lying—a banker could easily make $200 in a matter of seconds.

In both groups, workers from the red-blooded bit of banking—traders and the like—were more dishonest than those in ancillary jobs. Overall, however, the control group was quite honest: they reported that 52% of their tosses had been winners, only slightly above the probable outcome of 50%. The treatment group, in contrast, said that they had got lucky 58% of the time. Nearly a tenth of the treatment group claimed the full $200, despite there being a one-in-a-thousand chance of this happening to an honest flipper.

It was not merely talk of stocks and shares that made people more deceitful: when the authors tried that trick on non-bankers, there was no effect. And people in other professions—say, those in computing and pharmaceuticals—did not become more dastardly when the researchers asked them about their work.

The authors posit that the discussion of work may have put the treatment group into a more materialistic frame of mind: more of them than in the control group agreed with the notion that social status was primarily determined by financial success, for example. Another possibility, about which the authors are sceptical, is that the people in the treatment group were more prepared to lie because their professional identity had taken centre-stage; the feelings of the person inside the suit became less important.

Banks say they are trying to stamp out dishonesty among their staff. Some now make employees attend ethics classes. The researchers want bankers to take the financial equivalent of the Hippocratic Oath, doctors’ promise to “do no harm”. The Netherlands introduced one at the beginning of 2013, in which moneymen solemnly affirm their “responsibility towards society”. But it may not be the bankers who are the problem so much as the setting.

SNB INTRODUCES NEGATIVE INTEREST RATES

Swiss National Bank introduces negative interest rates

Minimum exchange rate reaffirmed, and target range for threemonth

Libor lowered into negative territory

The Swiss National Bank (SNB) is imposing an interest rate of –0.25% on sight deposit

account balances at the SNB, with the aim of taking the three-month Libor into negative

territory. It is thus expanding the target range for the three-month Libor to –0.75% to 0.25%

and extending it to its usual width of 1 percentage point. Negative interest will be levied on

balances exceeding a given exemption threshold.

The SNB reaffirms its commitment to the minimum exchange rate of CHF 1.20 per euro, and

will continue to enforce it with the utmost determination. It remains the key instrument to

avoid an undesirable tightening of monetary conditions resulting from a Swiss franc

appreciation. Over the past few days, a number of factors have prompted increased demand

for safe investments. The introduction of negative interest rates makes it less attractive to hold

Swiss franc investments, and thereby supports the minimum exchange rate. The SNB is

prepared to purchase foreign currency in unlimited quantities and to take further measures, if

required.

An instruction sheet containing additional information on the negative interest rate and the

calculation of the exemption threshold is attached.

http://www.snb.ch/en/mmr/reference/pre_20141218/source/pre_20141218.en.pdf

YEN SEEN AT 200 BY OPPOSITION LAWMAKER DOUBTING ABE

Takeshi Fujimaki, a banker turned opposition lawmaker, said the yen will slide to 200 per dollar once the Bank of Japan can no longer “camouflage” the nation’s default risk.

The yen has dropped more than 20 percent since April 2013 as the BOJ bought Japanese government bonds, reducing borrowing costs on the world’s heaviest debt load to below zero on notes maturing in two years or less. The currency traded at 119.42 per dollar as of 10:12 a.m. in Tokyo. The cost to protect JGBs against non-payment climbed to a 13-month high of 62 basis points yesterday after Moody’s Investors Service cut the sovereign rating ahead of the Dec. 14 elections called by Prime Minister Shinzo Abe.

“Once investors see Japan’s fiscal default through the BOJ’s camouflage, the yen will spiral out of control to 200 per dollar and beyond,” Fujimaki, a former adviser to investor George Soros and who won his upper house seat on a Japan Restoration Party ticket in July 2013, said in an interview in Tokyo on Dec. 1. While the currency will only drop to 140 next year, he said, “we’re still at the early part of the yen’s large-scale depreciation.”

Japan’s lower-house election campaign officially started yesterday, with the focus on Abe’s economic policies after the country slid into recession. Some opposition lawmakers have pointed out that the weaker yen is raising costs for consumers, while others say Abe must reduce government spending. The ruling Liberal Democratic Party says Abenomics has created jobs and spurred a rally in financial and property markets.

‘Deflationary Mindset’

Abe called the election to seek public support for his decision last month to postpone a sales-tax increase needed to rein in Japan’s ballooning debt by 18 month. When the BOJ expanded monthly bond purchases to as much as 12 trillion yen ($100 billion) on Oct. 31, it cited a risk that weak demand and cheaper oil could delay an end to Japan’s “deflationary mindset.”

Consumer prices excluding fresh food increased an annual 2.9 percent in October slowing from 3 percent in the previous month, official data showed Nov. 28. Stripped of the effect of April’s consumption levy increase, core inflation was 0.9 percent, less than half of the BOJ’s 2 percent target.

“The BOJ used consumer prices as an excuse to add stimulus and continues to hide that it’s monetizing government debt,” said Fujimaki. “But the truth is that Japan will default unless the BOJ continues to buy JGBs even after inflation accelerates beyond its intended target. The failure to push ahead with the planned increase in the consumption levy is a sign of a weak government.”

Opinion Polls

Two years after Abe’s Liberal Democratic Party and coalition partner Komeito defeated the then-ruling Democratic Party of Japan in a landslide, opinion polls show Abe has retained relatively strong support, while backing for the opposition is split among six smaller parties.

The LDP will be the choice of 28 percent of voters for the 475-member lower house, compared with 10.3 percent for the DPJ, according to a Kyodo News poll published Nov. 29. The Japan Innovation party, which was created from the Restoration Party and the Unity Party in September, had 3.3 percent support.

The BOJ’s easing contrasts with the Federal Reserve’s decision in October to end a third round of quantitative easing because of an improved labor market.

‘Helicopter Money’

“The U.S. ended tapering and stopped dropping helicopter money, while Japan is forced to continue to prevent a fiscal default,” Fujimaki said, citing Milton Friedman’s example of executing monetary stimulus by dropping cash from helicopters. “It’s clear the dollar will strengthen,” said Fujimaki, who recommends holding assets denominated in the U.S. currency.

Standard & Poor’s said yesterday its view of Japan hasn’t changed since October, a day after a ratings cut by Moody’s from Aa3 to A1, the fifth highest investment grade. S&P rates Japan at AA-, equivalent to the Aa3 level at Moody’s before the reduction. Fitch Ratings has Japan at A+, the same as the new rating from Moody’s.

A tax increase may be an important measure, but it’s unclear if the benefits would have been as great as anticipated, said Takahira Ogawa, director of sovereign ratings at S&P in Singapore.

Fitch plans to complete a review of the nation’s ratings before the end of the year, Andrew Colquhoun, the company’s head of Asia-Pacific sovereigns said last month, saying that the delay in the tax move is a “significant development” for Japan’s credit rating profile.

‘Chain Reaction’

“The bond market is calm in the aftermath of Moody’s downgrade and a sudden surge in yields is unlikely because the BOJ has been serving as a pain killer,” Hideo Kumano, an economist at Dai-ichi Life Research Institute and former BOJ official, wrote in a note yesterday. “But we should be mindful of the possibility of additional downgrades in a chain reaction.”

Japan’s 10-year benchmark bonds yielded 0.45 percent, the lowest globally after Switzerland. The two-year yield fell below zero for the first time last week reducing borrowing cost for the government with more than 1 quadrillion yen in national debt.

Fujimaki joined the Tokyo office of Morgan Guarantee Trust Co., which merged into JPMorgan Chase & Co., in 1985 and later served as managing director and treasurer, helping to make it reach the most profitable foreign bank in Japan.

After correctly picking the 1990s rally in JGBs, he was hired by Soros Fund Management, once the world’s biggest hedge fund group, in 2000. He stayed less than a year, saying to Bloomberg News at the time that he failed to read the Japanese bond market correctly. He has been predicting an eventual default in Japan since at least 2009.

“The BOJ’s QE will cause bad inflation or hyper inflation,” Fujimaki said.

THE NITTY - GRITTY ABOUT THE EURCHF FLOOR

Due to the recent discussion about the EURCHF  peg, I  would like to share a few things about the currency  :

·         SNB is using a floor  for  a second time in its history. The first one was introduced on 01/10/1978  (DEM/CHF floor at  0.80 CHF)

·         In addition to  the first  floor , SNB had also  introduced administrative measures(e.g ban  of paying interest to foreign deposits)  to address the  strong currency 

·         The peg  lasted  3 years .  In 1981 the Central  bank  abandoned the peg to curb inflation. None the less  currency  never  broke the floor.

·         In  September  2012  the Swiss Central Bank introduced again the  floor  to 1.20 to  curb the  pressure on CHF due to  European crisis

·         SNB has repeatedly  stated  that will “defend this cap  with utmost determination and stands ready  to buy  unlimited amounts of foreign currency “

So what  can make the SNB to abandon the floor? The only  reason is  Inflation .  SNB will be forced  to abandon the floor in case inflation start rising. 

Are we there yet  ?  Not even by  a long shot as it  can be seen in the graph   below .

CURRENT TRADES

long EURGBP AND EURCHF

short  audusd  0.1 at 0.8770 sl 0.90 tp  0.82

14/11/2014	LONG		0,2	EURGBP	0,7989	0,779		0,819	0,84
16/11/2014	LONG		0,2	EURGBP	0,793	0,779		0,819	0,84
14/11/2014	LONG		0,2	EURCHF	1,2015	1,18		1,23

TRADE OF THIS WEEK : GOING LONG USDCHF AT OPENING SL 0.95 TP 0.99

I will  go  long 0.20 lots  usdchf at opening target 0.99 and sl  0.95

"DEFLATION :MAKING SURE "IT" DOESNT HAPPEN HERE" BY BEN BERNANKE / NOVEMBER 2002

Since World War II, inflation--the apparently inexorable rise in the prices of goods and services--has been the bane of central bankers. Economists of various stripes have argued that inflation is the inevitable result of (pick your favorite) the abandonment of metallic monetary standards, a lack of fiscal discipline, shocks to the price of oil and other commodities, struggles over the distribution of income, excessive money creation, self-confirming inflation expectations, an "inflation bias" in the policies of central banks, and still others. Despite widespread "inflation pessimism," however, during the 1980s and 1990s most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon. Although a number of factors converged to make this happy outcome possible, an essential element was the heightened understanding by central bankers and, equally as important, by political leaders and the public at large of the very high costs of allowing the economy to stray too far from price stability. With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem--the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation--a decline in consumer prices of about 1 percent per year--has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump. So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow. Flexible and efficient markets for labor and capital, an entrepreneurial tradition, and a general willingness to tolerate and even embrace technological and economic change all contribute to this resiliency. A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape. Also helpful is that inflation has recently been not only low but quite stable, with one result being that inflation expectations seem well anchored. For example, according to the University of Michigan survey that underlies the index of consumer sentiment, the median expected rate of inflation during the next five to ten years among those interviewed was 2.9 percent in October 2002, as compared with 2.7 percent a year earlier and 3.0 percent two years earlier--a stable record indeed. The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief. Of course, we must take care lest confidence become over-confidence. Deflationary episodes are rare, and generalization about them is difficult. Indeed, a recent Federal Reserve study of the Japanese experience concluded that the deflation there was almost entirely unexpected, by both foreign and Japanese observers alike (Ahearne et al., 2002). So, having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether. Accordingly, I want to turn to a further exploration of the causes of deflation, its economic effects, and the policy instruments that can be deployed against it. Before going further I should say that my comments today reflect my own views only and are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee. Deflation: Its Causes and Effects 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 declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines. 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.1 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. 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." Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, thereal interest rate paid by borrowers equals the expected rate of deflation, however large that may be.3 To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn. Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value. When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard.4 The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year. Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.5 Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible. However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy. Preventing Deflation As I have already emphasized, deflation is generally the result of low and falling aggregate demand. 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. Beyond this commonsense injunction, however, there are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation. First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero.6 Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times. Second, the Fed should take most seriously--as of course it does--its responsibility to ensure financial stability in the economy. Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks. Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates (Orphanides and Wieland, 2000; Reifschneider and Williams, 2000; Ahearne et al., 2002). By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails. As I have indicated, I believe that the combination of strong economic fundamentals and policymakers that are attentive to downside as well as upside risks to inflation make significant deflation in the United States in the foreseeable future quite unlikely. But suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed's policy instrument--the federal funds rate--were to fall to zero. What then? In the remainder of my talk I will discuss some possible options for stopping a deflation once it has gotten under way. I should emphasize that my comments on this topic are necessarily speculative, as the modern Federal Reserve has never faced this situation nor has it pre-committed itself formally to any specific course of action should deflation arise. Furthermore, the specific responses the Fed would undertake would presumably depend on a number of factors, including its assessment of the whole range of risks to the economy and any complementary policies being undertaken by other parts of the U.S. government.7 Curing Deflation Let me start with some general observations about monetary policy at the zero bound, sweeping under the rug for the moment some technical and operational issues. As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal. What has this got to do with monetary policy? 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. Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. 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.9 There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well. 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. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association). Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.10 Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding.11 For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt. To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly.12 However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window.13 Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.14 For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.15 The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.16 I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar. Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, 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. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation. Fiscal Policy Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.18 Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets. Japan The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points. First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan. Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve. In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States. Conclusion Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.19 References Ahearne, Alan, Joseph Gagnon, Jane Haltmaier, Steve Kamin, and others, "Preventing Deflation: Lessons from Japan's Experiences in the 1990s," Board of Governors, International Finance Discussion Paper No. 729, June 2002. Clouse, James, Dale Henderson, Athanasios Orphanides, David Small, and Peter Tinsley, "Monetary Policy When the Nominal Short-term Interest Rate Is Zero," Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series No. 2000-51, November 2000. Eichengreen, Barry, and Peter M. Garber, "Before the Accord: U.S. Monetary-Financial Policy, 1945-51," in R. Glenn Hubbard, ed., Financial Markets and Financial Crises, Chicago: University of Chicago Press for NBER, 1991. Eggertson, Gauti, "How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible," unpublished paper, International Monetary Fund, October 2002. Fisher, Irving, "The Debt-Deflation Theory of Great Depressions," Econometrica (March 1933) pp. 337-57. Hetzel, Robert L. and Ralph F. Leach, "The Treasury-Fed Accord: A New Narrative Account," Federal Reserve Bank of Richmond, Economic Quarterly (Winter 2001) pp. 33-55. Orphanides, Athanasios and Volker Wieland, "Efficient Monetary Design Near Price Stability,"Journal of the Japanese and International Economies (2000) pp. 327-65. Posen, Adam S., Restoring Japan's Economic Growth, Washington, D.C.: Institute for International Economics, 1998. Reifschneider, David, and John C. Williams, "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit, and Banking (November 2000) Part 2 pp. 936-66. Toma, Mark, "Interest Rate Controls: The United States in the 1940s," Journal of Economic History (September 1992) pp. 631-50.

Footnotes 1. Conceivably, deflation could also be caused by a sudden, large expansion in aggregate supply arising, for example, from rapid gains in productivity and broadly declining costs. I don't know of any unambiguous example of a supply-side deflation, although China in recent years is a possible case. Note that a supply-side deflation would be associated with an economic boom rather than a recession. Return to text 2. The nominal interest rate is the sum of the real interest rate and expected inflation. If expected inflation moves with actual inflation, and the real interest rate is not too variable, then the nominal interest rate declines when inflation declines--an effect known as the Fisher effect, after the early twentieth-century economist Irving Fisher. If the rate of deflation is equal to or greater than the real interest rate, the Fisher effect predicts that the nominal interest rate will equal zero. Return to text 3. The real interest rate equals the nominal interest rate minus the expected rate of inflation (see the previous footnote). The real interest rate measures the real (that is, inflation-adjusted) cost of borrowing or lending. Return to text 4. Throughout the latter part of the nineteenth century, a worldwide gold shortage was forcing down prices in all countries tied to the gold standard. Ironically, however, by the time that Bryan made his famous speech, a new cyanide-based method for extracting gold from ore had greatly increased world gold supplies, ending the deflationary pressure.Return to text 5. A rather different, but historically important, problem associated with the zero bound is the possibility that policymakers may mistakenly interpret the zero nominal interest rate as signaling conditions of "easy money." The Federal Reserve apparently made this error in the 1930s. In fact, when prices are falling, the real interest rate may be high and monetary policy tight, despite a nominal interest rate at or near zero. Return to text 6. Several studies have concluded that the measured rate of inflation overstates the "true" rate of inflation, because of several biases in standard price indexes that are difficult to eliminate in practice. The upward bias in the measurement of true inflation is another reason to aim for a measured inflation rate above zero. Return to text 7. See Clouse et al. (2000) for a more detailed discussion of monetary policy options when the nominal short-term interest rate is zero. Return to text 8. Keynes, however, once semi-seriously proposed, as an anti-deflationary measure, that the government fill bottles with currency and bury them in mine shafts to be dug up by the public. Return to text 9. Because the term structure is normally upward sloping, especially during periods of economic weakness, longer-term rates could be significantly above zero even when the overnight rate is at the zero bound. Return to text 10. S See Hetzel and Leach (2001) for a fascinating account of the events leading to the Accord. Return to text 11. See Eichengreen and Garber (1991) and Toma (1992) for descriptions and analyses of the pre-Accord period. Both articles conclude that the Fed's commitment to low inflation helped convince investors to hold long-term bonds at low rates in the 1940s and 1950s. (A similar dynamic would work in the Fed's favor today.) The rate-pegging policy finally collapsed because the money creation associated with buying Treasury securities was generating inflationary pressures. Of course, in a deflationary situation, generating inflationary pressure is precisely what the policy is trying to accomplish. An episode apparently less favorable to the view that the Fed can manipulate Treasury yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling at the short end and buying at the long end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.Return to text 12. The Fed is allowed to buy certain short-term private instruments, such as bankers' acceptances, that are not much used today. It is also permitted to make IPC (individual, partnership, and corporation) loans directly to the private sector, but only under stringent criteria. This latter power has not been used since the Great Depression but could be invoked in an emergency deemed sufficiently serious by the Board of Governors. Return to text 13. Effective January 9, 2003, the discount window will be restructured into a so-called Lombard facility, from which well-capitalized banks will be able to borrow freely at a rate above the federal funds rate. These changes have no important bearing on the present discussion. Return to text 14. By statute, the Fed has considerable leeway to determine what assets to accept as collateral. Return to text 15. In carrying out normal discount window operations, the Fed absorbs virtually no credit risk because the borrowing bank remains responsible for repaying the discount window loan even if the issuer of the asset used as collateral defaults. Hence both the private issuer of the asset and the bank itself would have to fail nearly simultaneously for the Fed to take a loss. The fact that the Fed bears no credit risk places a limit on how far down the Fed can drive the cost of capital to private nonbank borrowers. For various reasons the Fed might well be reluctant to incur credit risk, as would happen if it bought assets directly from the private nonbank sector. However, should this additional measure become necessary, the Fed could of course always go to the Congress to ask for the requisite powers to buy private assets. The Fed also has emergency powers to make loans to the private sector (see footnote 12), which could be brought to bear if necessary. Return to text 16. The Fed has committed to the Congress that it will not use this power to "bail out" foreign governments; hence in practice it would purchase only highly rated foreign government debt. Return to text 17. U.S. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Washington, D.C.: 1976. Return to text 18. A tax cut financed by money creation is the equivalent of a bond-financed tax cut plus an open-market operation in bonds by the Fed, and so arguably no explicit coordination is needed. However, a pledge by the Fed to keep the Treasury's borrowing costs low, as would be the case under my preferred alternative of fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut taxes. Some have argued (on theoretical rather than empirical grounds) that a money-financed tax cut might not stimulate people to spend more because the public might fear that future tax increases will just "take back" the money they have received. Eggertson (2002) provides a theoretical analysis showing that, if government bonds are not indexed to inflation and certain other conditions apply, a money-financed tax cut will in fact raise spending and inflation. In brief, the reason is that people know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation. Hence they will believe the government's promise not to "take back" in future taxes the money distributed by means of the tax cut. Return to text 19. Some recent academic literature has warned of the possibility of an "uncontrolled deflationary spiral," in which deflation feeds on itself and becomes inevitably more severe. To the best of my knowledge, none of these analyses consider feasible policies of the type that I have described today. I have argued here that these policies would eliminate the possibility of uncontrollable deflation. Return to text