The spectre haunting Federal Reserve monetary policy is the fear of deflation. A prolonged period of falling prices presses down on both the productive and the consumption sides of the economy. Businesses lose pricing power and face shrinking revenues even if they maintain sales levels. Consumers, frightened by job losses and discouraged by the collapse in family wealth postpone purchases, particularly of large items like homes and cars. Businesses with falling revenues fire workers, who buy less and in turn business production takes another leg down and employment follows.

Historically deflation is rare and associated only with severe economic contractions. If we take Milton Friedman's dictum “that inflates is always and everywhere a monetary phenomenon” then the primary sin of the Federal Reserve bankers in the Depression was their restriction of the money supply. This is the sin that Ben Bernanke is determined not to repeat.

A look at the chart below show how close we have come in a very short time to a touch of official deflation. In February the headline inflation rate was only 0.2% higher than a year earlier. It has fallen precipitously since oil prices peaked last summer. The core rate has remained more stable, 1.8% higher year on year in February. But in a realistic sense neither of these rates reflects what the consumer sees in his day to day life. These rates only partially represent the inflation expectations that go into consumer decisions. The unstated inflationary partner is asset prices. Home prices have fallen 20% and more in many parts of the country. It is immaterial whether those prices were real. Most homeowners did not sell their homes to cash in the appreciation. But as a backstop for family finances and a promoter of consumption from actual cash flow the sense of wealth from one’s house was a large, albeit incalculable, support for US consumption. If the collapse of asset prices is factored into the inflation/deflation rate the resulting rate would tilt much farther toward deflation.

United States Inflation Year/Year

The Fed’s basic problem with the US economy is simple, how to create enough inflation, enough money, to prevent deflation? Re-inflation is a more accurate term for the Fed’s goal than outright inflation. ECB officials have been more straightforward about their 2.0% target rate. They have said that is a goal from above and below. They do not mean 2.0% or lower; they mean 2.0%. The same is true for the Fed.

Mr. Bernanke has made it clear from the very beginning in September 2007 with the Fed’s first rate cut that he judges the situation to be a first order crisis and that the monetary parallel to the Depression is its most important feature. Federal Reserve policy has flooded the US economy with funds and provided dollar liquidity to much of the rest of the world though central bank lines.

The timing of the Fed’s quantitative easing announcement on Wednesday was a surprise. But Chairman Bernanke has often stated his intention to continue expanding the money supply beyond the end of rate easing. The Fed Funds rate cannot go lower; the Fed has started quantitative additions to the money supply, just as he said they would.

The effect on the dollar and on the currency markets of the easing announcement was one of shock and concern. The shock was standard for unexpected news of this import. The dollar lost 4.2% against the euro in three hours, 6.3% in less than 24 hours.

For dollar bulls the concerns were twofold: why now? Is the economic situation worse even than the statistics tell us? And secondly, how much more will the Fed do? With the US deficit set to explode onto world credit markets is the Fed setting up to be the government’s banker? Mr. Bernanke has made a cogent argument for expanding the money supply to forestall the deflationary spiral of falling prices, employment and production. But is it doubtful his research included monetizing trillions of dollars of US Federal government debt for a decade or more. It is also doubtful the current American administration would object very strenuously to such monetization.

If the ECB also operates a large quantitative easing program the effect of the Fed’s actions will be muted. At 1.50% ECB rates are still more than a full point above the US. Even if the European bank governors shed their public reluctance and drop rates to 0.5% as many observers expect, their ability to move to quantitative easing is constrained. As a practical matter it would be far more difficult to enact a quantitative easing policy across all 16 euro members; politically it might be next to impossible

When market assumptions about the euro and the dollar changed last July, the US currency benefited twice over. Interest rates in Europe began a reduction cycle and the supposed immunity of the EMU to American generated economic turmoil was shattered. Since higher ECB rates and European immunity had supported the euro against the dollar when those assumptions disappeared the euro crashed. The September and October financial panic added safety to the dollar’s new found virtues.

The beginning of quantitative easing calls all three ideas in question; it increases the supply of dollars effectively lowering US interest rates well below Europe’s; the need for such an unprecedented step undermines the hope for a US recovery; and a devaluing dollar cannot be a safe haven. Add the projected Federal deficits and the dollar begins to look very vulnerable. If the Europeans go down the same quantitative road then the dollar’s disabilities may be matched by the euro’s. But if they are not then the Bernanke dollar call may not be an option to buy but a call to sell.