Now that the Federal Reserve has committed to keeping interest rates at rock-bottom levels well into 2013, many pundits have been saying that the central bank essentially is out of bullets when it comes to giving the economy a shot. And while there might not be another bond-buying plan like the quantitative-easing part II, QE2, stimulus in our immediate future, the Fed’s fiscal firepower is far from empty. In fact, there are many things the Fed still can do to stave off any kind of deflationary developments, and to combat any drift toward a depression-like scenario.
So, what are some of the things the Fed can still do to combat deflation? Well, for one thing, it can introduce more inflation into the system. How can it do that? Well, here are just a few of the bullets left in the central bank’s arsenal.
1) Purchase of U.S. private debt securities. Although the Fed does not have authority to purchase private securities directly, it could work with banks to make this happen. It would do so by offering guaranteed fixed rate 0% financing for banks for the duration of the securities purchased.
2) Purchase of foreign debt securities. Given the troubled debt situation in Europe, the Fed could inject more money into the system by essentially buying it from elsewhere. In fact, the quantity of foreign assets eligible for purchase by the Fed is several times the quantity of U.S. government debt.
3) Purchase of equities on domestic and/or foreign stock markets. The Fed could essentially prop up the value of stocks by becoming a big buyer of domestic and foreign equities.
4) Devaluation of the U.S. Dollar. The Fed can intervene in currency markets by purchasing and hoarding foreign currencies with newly minted U.S. dollars. This would stimulate inflation, but it also would stave off deflation.
5) Accommodation of fiscal deficits. This is essentially Fed-enabled deficit spending in the form of direct spending via the government. This is what economist Milton Friedman famously called a “helicopter drop” of money into an economy.
I think the Fed is going to institute some kind of plan to stave off deflation and a recession, as its leaders realize that recession is about the worst thing that can happen for financial markets and for the economy right now. In exchange for staving off recession, the Fed is willing to pay the inflationary price.
This could be good for assets like gold, and even the stock market. And while it may be bad for consumers, the Fed sees the deflation/recession/depression scenario as a much more pernicious outcome for the entire global economy.