A different paradigm

The first new fundamental is the perception the 50-basispoint Fed rate cut in September (with two more being built in for the Oct. 31 and Dec. 11 Fed meetings) will cause inflation. This is why the prices of oil and gold are rising so dramatically.

Behind the scenes, however, one of the real fears at the Fed is deflation. The bursting of an asset bubble and a subsequent recession always has the potential to become deflationary, and nobody knows it better than Fed chief Ben Bernanke, an expert on the Great Depression of the 1930s. That’s one of the reasons the rate cut was double the expected amount — Bernanke wanted to shock the markets.

Mr. Bernanke got a bad rap when journalists started calling him “Helicopter Ben” after he suggested that deflation could be whipped by “throwing cash out of helicopters” — i.e., increasing the money supply. Deflation was considered a possible outcome of recession in 2002, and Bernanke was arguing the Fed could cure it via the money supply. This is a generally accepted concept by economists. The idea of a helicopter drop actually came from Milton Friedman, the father of monetarism (“Inflation is always and everywhere a monetary phenomenon”).

It’s one of the dirty little secrets of central banking that economists, for all their sophisticated models, honestly do not know how inflation and deflation come about. We don’t understand the role of expectations, and it’s pretty certain that former Fed chairman Alan Greenspan’s explanation of the failure of inflation to appear in the early 2000s — the productivity miracle — was his usual smoke and mirrors. In fact, touting his new book on talk shows in late September, he admitted that central bankers do not understand inflation any better today than they did 50 years ago.

We don’t want to overstate the possibility of deflation in the U.S., but the probability is not zero.