Extend And Pretend; Or Why The Inflation/Deflation Debate Is Largely Irrelevant
Inflation or deflation? The debate is at the heart of every argument about capital markets, fiscal policy, monetary policy, debt management, the Federal Reserve, and thus by implication unemployment and politics in general. And like every popular debate, inflation has its fanatics: those who believe no matter what, their set outcome is the certain one. Yet is [inflation/deflation] such a certainty given all the prevailing data? Greg Mankiw shares some thoughts on why that may not be the case.
A brief primer on hyperinflation:
One basic lesson of economics is that prices rise when the
government creates an excessive amount of money. In other words,
inflation occurs when too much money is chasing too few goods.
second lesson is that governments resort to rapid monetary growth
because they face fiscal problems. When government spending exceeds tax
collection, policy makers sometimes turn to their central banks, which
essentially print money to cover the budget shortfall.
America's sad state of economic affairs is seen by many who read into the Fed Fund futures a little more than they should, as merely a preamble into a broader inflationary scare, as the old "Don't fight the Fed" tantra reappears, and spikes equities for all those who would rather be with the Fed chairman than against him. But is this correct?
The Federal Reserve
has also been rapidly creating money. The monetary base — meaning
currency plus bank reserves — is the money-supply measure that the Fed
controls most directly. That figure has more than doubled over the last
Yet, despite having the two classic ingredients for
high inflation, the United States has experienced only benign price
increases. Over the last year, the core Consumer Price Index,
excluding food and energy, has risen by less than 2 percent. And
long-term interest rates remain relatively low, suggesting that the
bond market isn’t terribly worried about inflation. What gives?
Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.
Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times. With banks content holding idle cash, the broad measure called M2 (including currency and deposits in checking and savings accounts) has grown in the last two years at an annual rate of only 6 percent.
The disconnect between capital markets and Fed reality becomes fully apparent when considering the market's reaction to the Fed's intervention over the past two years. Assuming the absence of direct Fed intervention in equities, which is becoming increasingly more problematic, equities are currently discounting a dramatic flare up in inflation, which is contrary to what most economic strategists and that old tried and true measure - the yield curve, are saying. Yet, when the Fed essentially controls a vast portion of the bond market via Q.E., its damaging interventionism become a self-fulfilling prophecy. While a steep yield curve in the past was indicative of an economy on the brink of growth, now all a steep curve implies is more Fed intervention in the future. The last time we checked planned economies did not work out too well. How America's capital markets can have fooled themselves to so blatantly accept Fed printing euphoria with a sustainable GDP bounce will be the topic of many textbooks in the future. In the meantime, the current equities bear market rising tide is as transient as the current Chairman's attempt to validate Keynesian economics... On a long enough timeline...
And while Bernanke aims for a Golidlocks monetary trajectory, he is certainly facing a dilemma. The macro economy's "strange attractor" is certainly a deflationary outcome, due to the $15+ trillion in household wealth lost in the span of just one year. There is no way that any amount of Fed "funny money" can replace this lost purchasing power, and the resultant shift to secular consumer psychology coupled with a demographic shift, which forces ever more assets to enter run-off mode to provide annuity streams to ageing baby-boomers.
And while deflation is what keeps Bernanke up at night, it is certain that inflation could be just as big a threat if the Fed does not contain its bubble-blowing ways in time.
First, a little bit of inflation might not be so bad. Mr. Bernanke
and company could decide that letting prices rise and thereby reducing
the real cost of borrowing might help stimulate a moribund economy. The
trick is getting enough inflation to help the economy recover without
losing control of the process. Fine-tuning is hard to do.
the Fed could easily overestimate the economy’s potential growth. In
light of the large fiscal imbalance over which Mr. Obama is presiding,
it’s a good bet he will end up raising taxes for most Americans in
coming years. Higher tax rates mean reduced work incentives and lower
potential output. If the Fed fails to account for this change, it could
try to promote more growth than the economy can sustain, causing
inflation to rise.
Finally, even if the Fed is committed to low
inflation and recognizes the challenges ahead, politics could constrain
its policy choices. Raising interest rates to deal with impending
inflationary pressures is never popular, and after the recent financial crisis,
Mr. Bernanke cannot draw on a boundless reservoir of good will. As the
economy recovers, responding quickly and fully to inflation threats may
prove hard in the face of public opposition.
Alas, in the search for an answer, capital markets provide no clue: equities push higher seemingly everyday, as they price in greater economic growth and higher inflation, while the bond complex, despite a record yield curve, still has the 30 Year trading at near record low yields. If inflation is truly a concern, do not look to the biggest and most rational market in the world. As we pointed out yesterday, unsubsidizided investors (aka non-Primary Dealers), foreign central banks are shifting to a longer duration exposure, even as equities should be raising at least some eyebrows that such a portfolio shift is premature. After all, if inflation does in fact pick up, look for the long end pricing to plunge. As such the steep 2s30s is not so much an indication of perceived tail and inflation risk, but of excess demand for the short end from domestic banks sitting on record amounts of excess reserves, who are happy to take advantage of the last great subsidy the Fed has afforded them: the steep yield curve. On the other hand, with all dominant market makers now on board and participating on the same side of the trade, more and more professionals are summoning those two status quo dreaded words: the Minsky Moment.
Regardless who ends up right in the [deflation/inflation] debate, one thing is certain - the Fed will without an iota of doubt mismanage the current "exit" process and the outcome will certainly be one which will further imperil the economic and political future of this country, as whether we end up with deflation, inflation or alternatively, stagflation, the days of King Dollar are numbered, and with it the zombified trance that America's middle class has helped its mindless trudge through the past decade. And if there is anything a ruling elite fears more than anything, it is the shift of the silent majority into a very vocal one. Facilitating this form of political suicide is the insanity which will be the current banker bonus season - allowing bankers to extract massive taxpayer capital arising from direct middle-class funding in the form of interventions, and dollar debasement in the form of the steep yield curve (funded through $2 trillion in Fed security holdings), on the back of imaginary marks-to-market which are there to "justify" Wall Street's record profits, with the complicity of the regulators and the accountants, is merely yet another transient house of cards which just like the housing bubble, will inevitably topple. Yet this time, with the budget deficit already running at 11%+ of GDP, the bailout will not come, or if it does, it will be on the back of a socialist-style, 60% tax for everyone and everything, which will be the last straw for America's economic and political back.