Helicopter Ben goes ZIRP, QE and More…While the Global Economy Enters Stag-Deflation

The Fed decision yesterday to cut the Fed Funds range to 0-0.25% formalized the fact that, over the last month, the Fed had already moved to a ZIRP (zero-interest-rate-policy) - as the effective Fed Funds rate was already close to zero -and started a policy of QE (quantitative easing) as its balance sheet has surged over the last few months from $800 billion to over $2 trillion. And – as discussed below – the Fed is now undertaking even more unorthodox policy actions.

These Fed policy actions are occurring while the US and the global economy is now risking a protracted bout of stag-deflation, a disease that I first discussed as early as January 2008 when I warned about the risk of a global deflation and stag-deflation. While it is now fashionable to talk about such deflationary risks – and the latest U.S. CPI figures confirm that we are entering into deflation – some of us were worrying about the coming deflation well before the mainstream – concerned with short-run and unsustainable increases in commodity prices – discovered the deflationary risks in the global economy.

It was clear to those of us that saw early on the risks of a severe US and global recession that, once that recession would emerge, deflationary rather than inflationary pressures would emerge as slack in goods markets, slack in labor markets and slack in commodity markets would emerge. So now we need to worry about stag-deflation, deflation, liquidity traps and debt deflation. Welcome to the world of stag-deflation or, as Krugman would put it, to the world of “depression economics”.

So what is the outlook for the US and the global economy in 2009? And what is the likely policy response to the risks of a global stag-deflation? Let us discuss next these two questions…