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Fed’s Fears Quietly Grow

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As the Fed gears up for next week's meeting on the state of the economy, they're quietly beginning discussions about the possibility of deflation. In Conspiracy of the Rich: The 8 New Rules of Money, I wrote about deflation being the Fed's greatest fear. Fed Chairman Ben Bernanke is famous for saying he'd rather throw money out of helicopters than allow deflation to happen in America.

The Fed fears deflation because it can't control it like inflation. In a normal economy, the Fed can ease inflation by raising interest rates. As the rates get higher, less debt is accumulated and less cash flows into the markets. Price increases ease as a result of less money chasing the same goods. But if deflation happens and prices plummet, the Fed can't do many things to prevent it.

Deflation can hang around for a long time like it has in Japan, which experienced a lost decade in the 1990s. During that decade, Japan's stock market dropped 63 percent despite the efforts of their central bank which pumped trillions of yen into their economy. Even today, the Japanese economy is slumbering and the confidence of its consumers is low. Just today, Japan's central bank announced plans to keep their interest rates at 0.01 percent and to launch a $33 billion credit program "to fuel economic growth and fight deflation."

Bernanke's greatest fear is that the US could fall into the same decades-long deflation that Japan is experiencing. As I wrote in Conspiracy of the Rich, Nixon removed the dollar from the gold standard in 1971. At that point, the dollar became debt.

Since 1971, the name of the game has been debt. If consumers and businesses don't go into debt, the economy doesn't grow. That is one reason for the recent recession—people maxed-out their credit. They used up their credit cards, pulled out their equity, and spent all their savings to buy liabilities like big screen TV's and nice cars.

In the face of deflation, the Fed is weighing options for propping up the economy and pumping even more funny money into the economy. According to an article in The Wall Street Journal entitled, "Fed Weighs Growth Risks": "The Fed's official posture is unlikely to change when policymakers meet June 22 and 23: The U.S. central bank is expected to leave short-term interest rates near zero and signal no inclination to change that for a long time. But behind-the-scenes discussions at the meeting could include precautionary talk about what happens if the economy doesn't perform as well as expected."

Worried about the effects of the US unemployment rate and the crisis in Europe, the Fed is quietly planning on how to fight deflation. They have three options.

Bonds away

The Fed can continue to reinvest funds from maturing bonds back into bonds. This keeps interest rates low by creating false demand as the Fed steps in to purchase bonds that investors won't.

Buying toxic debt

According to The Wall Street Journal, "During the financial crisis, the Fed purchased $1.25 trillion in mortgage-backed securities on top of buying debt issues by Fannie Mae, Freddie Mac and the U.S. Treasury." If the economy continues to falter, the Fed is considering buying even more toxic debt and assets, inflating their already bloated balance sheet.

Stepping up the rhetoric

Finally, the Fed can talk more. Like the loudmouth in class, they can try to steer the economic conversation to their liking and talk louder about how they plan on keeping interest rates low for an extended period of time. The hope would be that investors actually believe the rhetoric.

What you can do

Can the Fed keep deflation at bay? I doubt it. But it's clear that it will do everything in its power to prevent it.

As I blogged previously (Living on Borrowed Time), there are two types of depression, American-style depression and German-style depression. Very simply, the American-style depression is one of deflation. The German-style depression is one of hyperinflation. As I wrote in that post, I believe that we are headed for both types of depression. Unfortunately, the situation is out of control and I fear that the Fed can't do anything to stop a new depression from coming.

Just as the Fed is making plans, I'm making plans too. While prices are low, I'm taking advantage of deflation and preparing for the coming inflation. Currently, I'm using good debt—debt that puts money in my pocket through cash flow—to purchase cash-flowing assets. Deflation is exciting to me because I can buy great investments with cheap money. I'm also investing in gold, silver, and oil; and increasing my financial intelligence through financial education.

I encourage you to do the same. This is the greatest wealth transfer in history. Many will be decimated. Many who were rich in the last ten years will be poor in the next ten years. I want to see you become one of the rich.

Original publish date: June 15, 2010

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