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Obama, Democrats, Republicans AND Bernanke All in a Bind – What they will do and when
We
have two distinct groups in D.C. that are stuck between a very big rock
and a hard place. The first is the Federal Reserve. The second is the
Democrats and Republicans and the battle being waged over the debt
limit. I see a possible solution to these impasses. It’s so simple that I’m sure it is being considered. The prospect is scaring the crap out of me however.
The Fed is in a bind. The economy is clearly slowing down again.
Unemployment will soon follow. According to the Fed’s Dual Mandate they
should be doing something about that.
They have few options. They can’t do more Large Scale Asset Purchases
(“LSAP”). What has become referred to as “QE”, has not worked. It was
also very unpopular (both in and out of the country). LSAPs may come
back sometime, but they are on the shelf for at least a year. What could the Fed do in the near future?
I) They could increase the inflation target (core CPI) from “A little under 2%” to “A tad over 3%”.
II) They could alter the ZIRP (zero interest rates) language from: “For the foreseeable future” to: “Until such time as the Fed’s new inflation target has been achieved but not less than one year”.
These relatively minor changes would have very dramatic effects.
-Inflationary expectations would jump. Actual inflation would follow.
-The dollar would crap out. Exports would increase.
-This would result in wage pressure. Exactly what the Fed wants.
-The resulting inflation in all commodities would roll into new home
construction costs and therefore be a boost to existing values. (Soft bailout to housing/lenders)
-It is (short-term) supportive of equities. Exactly what the Fed wants.
-Debt costs can’t rise too fast as ZIRP keeps the belly of the curve cheap. This has to happen. Without LSAPs, this is the only way to achieve it.
Are you scared yet? Now consider where the politicians are on the inflation story.
Republicans have drawn a line in the sand on the debt limit with their position of “No New Taxes”. The Democrats have said pretty much the opposite with, “No spending cuts”.
Neither side appears to be giving an inch. There is no common ground.
Yet, to go to August 2 without a resolution is just a dumb move. Both
sides of this big debate know that the next presidential election is
riding on the outcome. If the US is to default; one side or the other
will shoulder the blame. The “side” that gets the blame will lose the election. And both sides understand this. So where’s the compromise?
The solution is inflation. The
government has got to get out of its inflation indexed obligations. You
don’t have to raise tax brackets to raise revenues or cut expenses. You can mess with inflation adjustments to achieve these ends. Both sides can appear to win if this is accomplished.
Consider the words last week of Brian Graff of ASPPA (Lobby for pensions and actuaries) (The conference was sponsored by the IRS!!)
"Eliminating
indexing is one of the proposals receiving serious consideration as
Congress enters “uncharted territory” with legislation to raise the debt
ceiling, If Congress were to stop indexing for a period of time, which
would affect tax brackets, individual retirement account contributions,
and contribution limits under tax code Section 415, “you could raise a lot of money, and those are the kinds of things they are talking about.”
On the expense side of the equation a great deal of fat can be cut by
eliminating/cutting COLA increases in a variety of programs. The most
important of which would be Social Security. Depending on how the cuts
in COLA are defined and how they are applied a huge amount of money
would be saved over an extended period.
If all social obligations had their COLA increases cut in half it would
(on paper) put the US on a much more solid long-term footing. It is a
very appealing “kick the can down the road” approach. No cuts in programs (just smaller increases) and no new taxes (but higher revenue as the inflation adjustments for AMT and other tax issues kick in).
If you buy into this thinking this is they way it could play out:
We DO go to the 11th hour on the debt limit. But a compromised is reached. Central to the deal is a broad restructuring of the way inflation impacts both revenue and expenses at the federal level. Both sides claim victory.
Two months later Bernanke will announce what will be called QE3. He will
make a long-term commitment (at least one year) to maintaining interest
rates at near zero levels. And he will raise the inflation target that
the Fed is hoping to achieve by 35% ('smidge' over 3% core CPI)
Should things play out along these lines it will be sea change series of
events. If anything like this were to be in our future the very worst financial position would be short gold and long bonds. Being short volatility in any market would also be a mistake. Outside of that, I’m not sure where/how to position for this.
My thoughts:
Deflation is scaring us to death. But inflation will kill us. And that is exactly what the ‘Deciders’ have in store for us.
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Using inflation to help the economy is like letting out blood to cure the patient...Rufusbird
Current unemployment CAN'T be fixed with monetary or fiscal policy. High unemployment in the US is structural. An insane regulatory environment has driven manufacturing offshore. Unemployment won't decline till Team Obama and the regulatory horsemen of the apocalypse are gone. Just in the last month these clowns have issued regulations that will force the shutdown of a quarter of the nation's coal fired power plants, told Boeing they can't hire thousands of people, and nearly made every farmer in America a Dodd-Frank regulated commodity dealer. What's needed are a low, simple, and STABLE tax policy; and logical, streamlined, de minimus regulations.
+1
...but we will get more clusterfuck, instead.
You are correct of course, inflation is what the politicians will serve us - it is mankind's history and will be its future. But inflation will make it more costly to raise new debt; even if they do away with indexing, deficit (hence new debt to raise) would still be huge. Inflation won't raise GDP because corporates will move offshore where costs are stable; nor will the remaining companies' profits rise because expenses would rise in tandem. It is a myth that a fall in nominal exchange rate will boost exports, study after study have shown that it is real exchange rate, not nominal that matters (see Menzies Chiin etc, and see how Japan's deflation offset the rising yen). Hence inflation would not raise employment, nor boost growth, nor provide a stable financial climate. The Fed would continue to fail in its "mandate" but succeed in transferring more wealth to the banks. But you are right, inflation is what is in store, and bond markets would finally collapse in a couple of years.
Blame for a default? I'll give credit where credit is due for defaulting on the bankster thieves.
"This would result in wage pressure. Exactly what the Fed wants."
No, this would increase layoffs as consumers are forced to cut back spending to pay for the higher prices in non-discretionary purchases. It would cause higher inflation overseas where most of the non-discretionary items originate from as the dollar losses value.
US exports are no where near competitive, when you consider that Asian and Indian wages are less than a dollar an hour. The US minium wage is over $7 USD which is about 7 times over the costs of Asian labor. That also doesn't include Business costs for labor (Payroll Tax, Unemployment Tax, Worker Benefits, etc).
Finally, Lower interest rates does not put money or loans in the hands of consumers. It does allow big bankers and other big wall street firms to borrow and speculate in commodities squeezing the consumers dry. The Fed has tried that since 2008 and there are fewer jobs today since before QE1 started. The only way the Fed could cause wage inflation is to literally drop piles of money from helicopters to get money directly into consumers hands. But that would crush the dollar causing hyper-inflation in months.
"Two months later Bernanke will announce what will be called QE3"
I am not so sure about that. I think they will just print money and target Treasury rates without any grand announcement. I think the Fed will tip-toe around any further QE announcement. Nobody is happy about the high gas and food prices. The Fed will go under the cover to print money for the next year or so.
"If all social obligations had their COLA increases cut in half"
That won't solve the problem. The Problem isn't existing entitlement recipients, its the Tsunumi of Boomers retiring and collecting entitlements. Every day 10K boomers file for retirement. This will increase since we are only at the very beginning of the Boomer retirement wave. It will grow from 10K per day to 25K per day in a few years. You need to stop the growth of recipients, not the COLA.
What we are going to end up is with a worthless dollar. No Politician that understands demographics is going to cut entitlements. Boomers + the retirees are the largest voting block. Tell them you going to cut their entitlements, and they will boot you out of office faster the Gray Davis was.
I'm not an actuary, but I suspect that if you tweak entitlements while bumping inflation it will add up very fast.
Have to square the circle somehow: If we can't grow the economy faster than entitlement-driven deficits, then we will have to grow the money supply to outrun the obligations.
Bruce, are you suggesting that the Fed can create sustained inflation merely by declaring a higher inflation target, without actually doing anything to expand the money supply? If so, I totally disagree.
The reason that the Fed's declarations of targets carry weight is that they have a long record of being followed up with concrete with policy actions. Until the 2008 crisis there was a very clear system: the Fed declared a fed funds rate target, and then either created or extinguished enough base money to move the actual fed funds rate near to that target. No one could predict how much base money would have to be created or extinguished to approximate the new target, but one could generally trust the Fed to keep on fiddling until the actual rate was fairly close to the target. Given that, markets would price in the Fed fiddling right off the bat so that rates adjusted quickly to the target.
The crisis and policy response changed all that. The old mechanism by which the Fed calibrated the actual fed funds rate does not work anymore, ever since the Fed started paying interest on excess reserves. Since the crisis, the policy announcements are what matter. During the peak of the crisis, the Fed's announced LSAP policies made clear that rates were going to near-zero, and they did. But the Fed never announced that. It repeatedly adjusted its target rates downward well after rates had already fallen to those levels or lower. After the target rate finally caught up with the real rate at near-zero, the Fed has continued to announce important money supply expansions without, of course, any adjustment in the target rate, since it was alread near-zero.
As for inflation-targeting, the Fed's legal mandate from Congress is "stable" prices, which literally means zero inflation. You're right that Bernanke has implied that the current FOMC has decided anyway to target a bit less than 2% core inflation, basically on pursuit of full employment grounds, but nobody on the FOMC has ever come out and said that explicitly. And they won't, because it would be in too obvious contradiction to their legal mandate.
Plus, even if the FOMC decided to somehow imply a higher inflation target, for it wto work markets would need to be convinced that the Fed would follow up with policy. Besides more QE, the only other inflationary policy I can think of would be lowering or eliminating the interest rate paid on excess reserves.
doublepost
oops!
tom,
Maybe, it no longer works because the machine is dead. I remember the fed and treasury playing together, also, but the capital is gone. The theory the other night here about a continual float having been created with the QE's and banks just rolling it to each other as required was interesting and it is pretty certain that this money has not entered the US economy-----it has never been spent, just permanently loaned to entities without capital that require capital each day.
I'm in over my head here after twenty years in the forest of southern ecuador, so---------------maybe someone will be able to direct my oversimplified and foggy brain to shelter. thanks
I'm talking about a very wonky issue: before November 2008, when Congress authorized the Fed to pay interest on banks' excess reserves, there was a more predictable relationship between base money supply and broad money supply. The Fed could fiddle with base money supply - accelerating its growth, decelerating its growth, theoretically although almost never in practice even stopping or reversing its growth - and know that broad money supply growth would accelerate or decelerate (or theoretically stop or reverse) in response. And it was ultimately by prompting those accelerations and decelerations of broad money supply growth that the Fed manipulated market interest rates. The Fed's target announcements were just promises to undertake the necessary fiddling with base money to produce the necessary response in broad money to move rates to approximately that target and keep them around there.
Now that the Fed pays interest on reserves, there is little direct relationship between base money supply and broad money supply. The Fed wanted it this way, so that it could hugely increase base money supply (as QE does) without hugely increasing broad money supply.
When interest on reserves is zero, Fed expansion of base money, which creates excess reserves, leads banks to expand lending up to the point where their reserve requirements grow and use up those excess reserves. The excess reserves become required reserves, and the expanded lending expands broad money. When the Fed pays interest on excess reserves, banks might instead choose to keep their excess reserves rather than use them to support increased lending, depending on economic conditions. When banks keep all or most excess reserves, changes in the pace of base money expansion have little or no effect on the pace of broad money expansion. The Fed in that way loses its ability to easily manipulate the broad money supply and market interest rates.
Currently, there is far more base and broad money than necessary to keep rates near zero. So if the Fed wanted to raise rates, it would have to extinguish a large amount of base money to make that happen, by selling its Treasurys and nullifying the dollars received. No one knows how much, because we've never been in anything like this situation before.
If Bernanke said, "ZIRP to last for at least a year" you would get a bump in the economy. It would push the inflation needle. This is a very powerful stimulus. More powerful than LSAPs IMHO.
We've had over 24 months of non-stop ZIRP on top of two and a half rounds of QE, and monentary authorities have signaled ZIRP will remain in place for the forseeable future.
Yet economic activity is slowing, unemployment picking back up, and housing prices are clerarly heading back south-- even though this last round of QE-plus-ZIRP hasn't even ended yet.
And you think Bernanke coming out and saying "at least one more year of ZIRP" will do the trick on inflation, when its actually incrementally less stimulus than what we are seeing today????
Good luck with that.
Find a away to convert ZIRP through the money multipler, and you might make yourself a much better case for inflation and growth. Unfortunately, the benefits of ZIRP are still being confined within the finanical system. Break that logjam, and you'll have all the inflation you'd ever want.
Agreed on that, since that's a promise about future policy. A promise not to tighten. OOnly a very small bump, though.
I don't know which way things will pop. 2012 elections are too important. Staying mostly in cash, and taking little bites out of the market until then. Mainly just GPL, GOV, and the deadly TZA/TNA pair. I don't see the debt limit being raised without massive (sic) 6 tril or more in cuts and an end to ethanol. Barely accounts for that damn Porculus included in the baseline, over 10 yrs.
Won't work. Fed is pushing on a string so it will not be able to get the debt bubble to grow much no matter how hard they try. Besides, higher inflation will also mean lower Treasury prices which will sink the USG who cannot afford higher rates when rolling over their enormous pile of debt. Not going to happen.
Bruce, I don't think its possible. Creating inflation without wage pressure will just push more people into bankruptcy. And with unemp this high, there is no way to get wages to rise.
I cannot help but notice the dozens, if not hundreds, of historical examples of inflation and hyperinflation which occurred in the face of, if not directly as a result of, the lack of a booming national economy and already-high unemployment.
The value of the Zimbabwe dollar did not plummet due to a runaway economy and ultra-low unemployment!
Please put away such fallacious Keynesian bunkum, or at least park it in a safe place before posting here.
Inflation and currency debasement are two different things. If Bruce thinks inflation will INCREASE house prices, he sure isn't referring to currency degbasement.
A nation can always debase its currency, but can't always create cost push inflation
Don't you mean "demand pull"?
Inflation and currency debasement are two different things.
Wrong.
They are the same thing. Both occur simultaneously when the currency issuer runs the printing presses, in this case the Fed. They're inflating the money supply which debases the currency.
The Fed only control M0+M1. They've been replacing M2+M3 money destruction by USG borrowing, but now that's hit a wall. They're cornered, or I should say we're cornered because the rest of what they need comes out of our hides not theirs.
Bruce, excellent piece. You are onto something. Carmen Reinhart has outlined her concept of "financial repression", whereby the government engineers negative real interest rates. This is accomplished by capping interest rates (ZIRP), as was done during the 50's and 60's. Redefining the COLA would be an elegant way to both decrease outlays and increase revenues. Part of the Reagan tax program was to index the brackets. Creating inflation in this way, along with the capping of interest rates would heighten negative real interest rates. The problem of course would be the unintended consequences.
Always be careful what you wish for;--)
AARP would all have their pacemakers go off and drop dead at this news...
I had no idea they were such good sports.
The AARP is going to object to anything. But this one, not so much. This is not a cut in benefits. This is a reduction in the rate of growth one might get. So it is definitely stealing, but it won't be perceived that way.
The theft won't come from one's pocket, it will come when one's pocket is emptied to buy "stuff". In this case stuff will be food and shelter. But that won't happen for another five to ten years or so.
Combine the cuts from inflation and Bernanke's plan to rev inflation up and you have a problem. But not today, tomorrow.
At that point government would have a natural tendency to step on the inflationary gas. It would make them "look good". That's the general plan I think.
Won't work. Fed is pushing on a string so it will not be able to get the debt bubble to grow much no matter how hard they try. Besides, higher inflation will also mean lower Treasury prices which will sink the USG who cannot afford higher rates when rolling over their enormous pile of debt. Not going to happen.
Yields out to about 5 years are driven by ZIRP. More than half of the debt is less than five years. There is very big capacity to absorb short term paper when borrowing costs are zero.
You are right that this is a problem for the long end of the curve. I said in the piece,"don't own bonds". But I am not so sure the two year moves a hell of a lot. That is now yielding 30bp.
Make ZIRP a minimum of a one year deal and there will be big demand for paper.
Two years after this happens is when it all starts to unwind. In other words, this would kick the can to the next president's first 5 months in office. Sort of like two years ago.
I doubt that they will be able to create much inflation. Like I said, "pushing on a string." When an economy is as over-leveraged as ours, the last thing people will want is more debt. The only real taker is the USG. Now, the biggest arguement in Congress is how much spending will be cut to bring the deficits down. IMHO, deflation will win...and that is exactly what bond yields are telling us right now.
As with all empire declines in history, the big spending cut comes with pulling in foreign military operations and reducing the military. The recent Afghanistan news was coincidental no?
The folks on SS got no COLA in 2010 because everything got cheaper in '09. Also, the old folks were reminded that they got a stimulus check in '09 and would get another in 2010 and they were keeping drug-plan premiums down. The base premium for Medicare part B went up 10% this year for people becoming eligible. And NOW, SSA is going to stop mailing statements and I never saw anywhere if/when they might resume so you don't get your estimated benefits in black & white anymore. This will end up extending to other programs.
Can someone explain to a non-money guy what could possibly be negative to ordinary schmucks if deflation occurs? What harm is there if our dollars increased in value?
If by "ordinary schmucks" you mean working people, then deflation is "scary" because of reduced prospects for improvement (no raises, no promotions, ...possibly no job).
It's okay for people who have large savings of cash, because their dollars will go farther with prices dropping, but if you're a worker, it's your price dropping.
Deflation sounds good in theory, though the details show why economists view it as the devil (I guess)
It's nice when things get cheaper, though it's no coincidence you are either unemployed, or, seriously worried about getting laid off. You are saving every dollar you can, because you are worried about your family, paying the bills, keeping them fed. A roof over their heads. You do need a refrigerator, though, but the price keeps going down! Instead of "buy something now, before the price goes up more" it's "I think I'll wait and see what the price is next week."
Meanwhile, the refrigerator factory is laying off another 200 due to sluggis sales. Rinse, lather, repeat. The great fear of deflation is a self-reinforcing or negative feedback loop. Food prices during the depression were very low - hamburger was a nickle a pound, except nobody had a nickle.
Whether this type of Great Depression scenario is possible under the current monetary system is above my paygrade. Looks to me like "they" might just destroy the underlying currency unit, at least for imported things especially. Kinda wacky.
-Nice explanation. However, this is so symmetric with the inflation targeting and pumping that the Fed does that it seems like an entirely natural process that should be permitted to balance things out. If f(x) is what the Fed is doing now, then this is f-1(x) and we all know f-1(f(x))=x, so we at least get something of value back as opposed to f(x)-->0 as x-->infinity, which is where the Fed is taking us now. (Whoops, looks like the inverse didn't show up properly on leaving the editor.)
The Paradox of Thrift.
(and everyone acts surprised when the store they were going to buy something cheap at "next week" closed last week)
The biggest problem with deflation is that while the value of the dollar is increasing, people spend less sensing that things will be cheaper in the future (Japan).
Japan never experienced any actual deflation (i.e., a rise in the purchasing power of its currency), nor has ANY nation under a fiat currency regime -- the very suggestion is ludicrous and historically unfounded.
What was the last thing you purchased in Japan?
So I have to have personally been in Japan for the last two decades to know that their cost of living did NOT fall during that period, but actually rose instead (as it always must under a fiat currency regime)?
For the last fucking time, the collapse of an asset bubble does NOT constitute "deflation"! Assets are NOT money!
No, you don't have to have been in Japan to know something about Japan but you obviously don't have a fucking clue either way.
Your arrogant ignorance when it comes to monetary matters would make Bernanke, Reich and Keynes himself proud.
That is certainly a concern with housing, which my own work tells me will continue to decline over the next few years, and likely reset at a much more realistic figure than pre-bubble. But that seems like a good thing, after the banks are liquidated and the fraud is exposed and the fraudsters are prosecuted. Only then, it seems to me, will people actually dare to risk anything to create business. Deflation seems self limiting if value can be ascertained. Only where continually obscured by government action is it opaque and undiscoverable.
^^ This
Without constant growth around 3% our social mandates will overwhelm us in a matter of years. So there has to be growth. At least that is what "they" are trying to tell you.
If we do not have growth unemployment would rise. When that happens the government responds with something that they pray will work. None of the things that have been done have worked. So they need a new gig. I think this is it.
PS If the dollar increasing in value by a significant amount (20%) you can kiss off the US economy. No exports, tons of imports. Forget about your Boeing and Cat and a few million jobs.
PS If the dollar increasing in value by a significant amount (20%)...
Forget it. There will be NO monetary deflation. Just monetary inflation. From here on out. As far ahead as you care to look.
Even suggesting the possibility of monetary deflation lumps you in with Leo K's insanity.
Thanks for thee reply. Sorry to be such a literalist, but if the growth is merely monetary, of what value is it anyway? Seems to me that if money became more valuable it would result in far greater purchasing power to pay off debt, and provide for an invigorated economy. Old folks would also get a boost in their savings, meaning that they might be able to sustain the first waves of rationality to wean dependents off the system. As far as the concern about buying all imported goods, I don't see that necessarily as a job destroyer. Seems like the job destroyers are b.s. like Obamacare and regulation and placing all energy sources in a lockbox of government control. Understand the tendency to expect continuing misconduct, but would you agree that a paradigm shift (to actual honesty) would work well with deflation?
What they are going to do is run up the debt to the furthest possible point, then the usury clan will cash in for as much sovereign control and natural resources they can plunder in exchange for the debt they sold us.
The central plan is to continually extract more and more wealth from the middle class via ANY means: the only criteria is to perform these thefts in the least detectable way by the masses. Dollar by dollar, we are being gently nudged toward 3rd world status.