The Fed is not helpless; it has two powerful tools left - but both are politically toxic. One is unsterilized foreign exchange intervention: buying foreign currencies with newly printed dollars, as the Swiss National Bank has done to hold down the franc. This would both stimulate net exports by pushing down the nominal value of the dollar, and alleviate deflation pressure by pushing up the price of tradable goods. (In theory, unsterilized intervention expands the money supply and ultimately, raises the price level, so the real exchange rate is unchanged even if the nominal exchange rate falls.) But the Fed won't do this without the Treasury’s approval, which for its part doesn't want the rest of the world accusing it of exporting its deflation.The Economist doesn't expect ZB to resort to these measures because of political risk. I think The Economist is too sanguine about what the economy will look like without such radical measures. The Fed drove us into a ditch. Let's see if Bernanke's helicopter can pull us out.
The other tool is a money-financed fiscal expansion: the infamous helicopter drop of money. Buying bonds on the secondary market, as the Fed already has done, stimulates demand only by lowering interest rates. Unless the banks take the money they got in exchange for the bonds they sold to the Fed, then plough it into other, riskier assets (like loans), there's no direct boost to boost aggregate demand. By contrast, buying newly issued bonds specifically to enable the federal government to spend more money would be a powerful boost to demand. But this needs the federal government to agree to a lot more fiscal stimulus and the Fed to set aside concerns about being the Treasury’s hand maiden. Neither looks likely.
Posted by | 7.23.2010 at 5:40 PM
Only two options left in his Toxic Toolkit: devaluation by helicopter drop or devaluation by flooding the FX markets.