Man the Helicopter; Investors Consider Others Ways Fed Could Stave Off Another Great Depression

June 6, 2012 3:37 PM EDT
With the federal funds rate being "zero bound" for years, the Fed has turned to unconventional methods to boost aggregate demand and avoid another Great Depression. However, with these programs now showing limited fruitfulness, investors are asking: what else can the Fed do?

Ben Bernanke's 2002 speech on deflation ("the helicopter Ben speech") has been a playbook of sorts to figure out his game-plan to battle the U.S. recession. Given the severe distress in Europe and economic data in the U.S. suggesting the horrible scenario of a double dip "great recession," however, it may be time for the Fed Chairman to go back to the well.

In this historical speech which took place before he was Fed Chairman, Bernanke discussed how in the event of a "zero bound" fed funds rate - where we have been for years - the Fed has other unconventional methods to boost demand. The most recently implemented method by Bernanke's Fed has been to lower interest rates on longer-dated treasuries bonds. Since September 2011, the Fed has been moving up the curve to boost the average maturity on its securities holdings. The impact on yields has been profound, with yields on the 10-year and 30-year treasuries at or near all-time lows. The 10-year last traded at 1.58 percent and the 30-year at 2.64 percent.

Yet despite the record low rates in treasuries, mortgages, auto loans, etc., aggregate demand remains weak. Given this, investors might be wise to look at the three other methods the Fed could boost the economy in unconventional ways.

Fiscal Policy:

Under this scenario, the Fed would work in conjunction with Congress to stimulate demand by getting cash in the hands of households. This can be done through tax cuts, or as Milton Friedman famously suggested, a “helicopter drop” of money. Bernanke explains: “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.”

Discount Window, other lending:

Like it did during the financial crisis, the Fed could offer fixed-term loans to banks at low or zero interest on a wide range of assets like corporate bonds, commercial paper, bank loans, and mortgages. While the Fed seeks to hold no credit risk, it could also make IPC (individual, partnership, and corporation) loans directly to the private sector.

While the Fed has already used these tools, it could easily expand their use.

Buy foreign government debt, domestic government debt

The quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt, giving the Fed a large pool to swim in.

Considering the situation in Europe, Bernanke & Co. could help bolster the Eurozone by buying bonds which would push yields down and monetize government debt. In addition, this move would expand the money supply and have forex implications.

While the Fed has committed to Congress that it will not use this power to “bail out” a foreign government, buying debt in France or other ‘safer’ Eurozone countries could be an option. The Fed could also come out in favor of Eurobonds.

Providing a “striking example” of how intervening to affect the exchange value of the dollar was handled in the past, Bernanke pointed out the scenario in U.S. history when Franklin Roosevelt devalued the dollar 40 percent against the dollar in 1933-34. Discussing the impact of this move, Bernanke said: “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.”

Don’t expect a move from Bernanke on any of these measures at this time. If anything, Bernanke & Co.'s next move would likely be to expand the bond-buying program. However, if things significantly deteriorate, astute traders might want to position their portfolio in the event that some of these unconventional methods are used. Gold (NYSE: GLD) and Silver (NYSE: SLV) would be easy places to move into.


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