Can We Stop Deflation?

A week or so ago, I heard a commentator on CNBC say that we should be worried about deflation because inflation can be stopped at any time, but that you can't stop deflation. I have been hearing this theme surprisingly often lately. If you hear anybody say this, don't ever take advice from them on anything dealing with economics because they have no idea what they are talking about.

If anything, inflation is the thing that could possibly not be stopped. The Fed bought up a bunch of near worthless assets back in 2008 and they will only be able to sell them back at a fraction of the price for what they paid. One option for fighting inflation down the road would be to increase the reserve requirements for banks, but even this is not a sure thing and beside the fact that it would not be supported by the banks (which work hand-in-hand with the Fed).

As far as price inflation goes though, if the public realized one day that the deficits are too high and our fiat currency is not backed by anything (like gold) and that the Fed will create mass quantities of new money, then a rush to the exits could mean the end of the dollar. If the demand for money goes down enough (high velocity), then it may not even matter how much money the Fed is creating. If enough people reject the currency, this in itself could sink it.

But let's move on to the deflation issue. This guy (and there are many more like him) think that the Fed can't stop deflation. Seriously, does this guy know anything about what the Fed does? The Federal Reserve can buy any asset that it wants with newly created money. The Fed could start buying stocks, old furniture, baseball cards, or farmland. Or it could keep buying U.S. treasuries. It doesn't matter. It could flood the market with new money. Ben Bernanke has said it himself. The Fed can create inflation just by credibly threatening to print money.

Of course, as has been discussed on previous posts, the Fed could also impose a negative interest rate on excess reserves held at the Fed by the banks. This would essentially force the banks to loan out their excess reserves. After a more than doubling of the monetary base, this in itself would create massive inflation.

It is one thing to predict that the Fed will take a deflationary course, but please don't listen to anyone who says that the Fed can't get out of a deflationary situation.