Anticipating Fed monetary policies are key to formulating investment theses. The link below is a peak into Fed Chairman Ben Bernanke's thoughts on fighting deflation before he became Chairman. It serves as a road map for policies the Fed has since deployed to counteract the financial crisis, including Quantitative Easing (purchase of Treasury bonds and mortgage-backed securities) and Operation Twist (selling short-term Treasuries and buying long-term Treasury bonds). See the excerpt below on FDR's dollar devaluation when he confiscated gold in 1933 (emphasis in
boldface is mine).
For those with time constraints, the key take away is the Fed's monetary policies are inherently inflationary, and explicitly devalue the USDollar. In other words, as long as these policies are in place, gold--priced in dollars, can only go up.
Contrast that to new Treasury Secretary nominee Jack Lew's declaration that the US Treasury will maintain its "strong dollar policy." Whatever.
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
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).
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.
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.
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.
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.
The 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.
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.
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