Deflation, or Inflation-what's your call?

Allan Meltzer: Bernanke’s Anti-Inflation Exit Strategy Will Fail –

The general public over the age of 40 has been pretty well educated to the dangers of inflation.  From the time we went off the gold standard in 1972, inflation has been paramount in the Federal Reserve mind.

Richard Nixon infamously tried to control prices by establishing a “Federal  Price Freeze” for a few months.  As a kid I remember seeing car ads on television advertising that you should buy now before the price freeze ends.

Gerald Ford replaced Nixon, and promptly started wearing a red lapel pin, “WIN”.  Whip Inflation Now it stood for.

Carter took office and threw gasoline on a smoldering fire.  If you look at a chart of short term interest rates during Carter’s years  (1976-1980) it’s a one way ticket higher.    I recall taking out a college loan for 3%, and reinvesting it in the money market for 19%, risk free!  The Carter years is when Keynesian economic concepts like the Phillips curve proved fallible.  Economic policies failed miserably.

Reagan campaigned on the misery index, a combination of unemployment and inflation.  He won, and his first priority was getting the US economic house in order.  Paul Volcker was the Fed chairman.  He embraced Milton Friedman’s idea of “monetism”.  If you could control the money supply, you could control inflation.

This theory has been with us at the Fed ever since Volcker was chair.  However, under Greenspan, they kind of abandoned it.  They thought that keeping track of M-1 through M-3 money supply numbers were not relevant to macroeconomics.

Since the financial crisis of 2008, the market has been very worried about inflation.  I recall traders buying loads of out of the money bond puts for December 2009 expiration, thinking that surely inflation would hit.  They lost money.

For sure, the Fed has increased the money supply by every means necessary.  So why doesn’t inflation ensue?

I think that the reason it doesn’t is three fold.  One, the velocity of many through the system is slow.  Money doesn’t turn over.  Consumers are saving more.  Unemployment is up.  Banks don’t lend.  Second, while the money supply has increased-where has it gone?  Big banks appetite for risk is way down.  Businessman cannot get loans.  The banks are borrowing at 0%, and reinvesting at 3% further out on the yield curve, purchasing government treasuries.  Third, in 2010, the tax cuts of 2001 come off.  So taxes are going up.  Business and consumers have figured in this tax hike into future plans.  So instead of using today’s tax rates as a guide to operations, they are pricing in the future higher rates.

How does the Fed end this cycle?  The article is correct in saying that paying interest on reserves is the wrong incentive.  Ironically, it might be reverse logic that breaks the jam of money velocity.  But the Fed can’t do it alone.  It needs cooperative fiscal policy from the government.

From the government perspective, Obama offered a few thoughts.  He talked about targeted cap gains cuts, and targeted incentives for hiring.  This is nice.  But really to get the party started the government needs to avoid picking winners and losers.  Offer a cap gains tax holiday for everyone.  As a matter of fact, since it’s a tax on productive capital, I would end the tax altogether.  This would change the CFO math used to pick out positive value capital projects and more of these would get done.  Ending cap gains would also increase the appetite for entrepreneurial risk taking.  More small business would start up. This would spur bank lending.

Meanwhile, the Fed can do a few things.  One, it can start taking less exotic things as collateral.  It amended it’s rules to allow all kinds of things as collateral while banks got healthy  in 2009.  This will force the bank to look outward to invest in things to get yield.  We want to end the cycle of banks borrowing at 0% and reinvesting risk free at 3%.  The Fed might also consider a small interest rate rise, so that it is more expensive for banks to borrow and reinvest at 3%.  There is still a lot of uncertainty in the world wide economy, so I doubt rates would skyrocket with a slight, .25 increase.

This would begin to move money out and into the economy.  Then the Fed would have to act quickly once it saw inflation getting out of control.  It would naturally be behind the curve, but I don’t think too far behind.

Meanwhile, the Federal government could curb spending-reducing it’s borrowing costs adding downward pressure on interest rates.

I think that plan eases us out of the environment we are in.

  • The treasuries are telling us we are still in a deflationary spiral. A friend of Jeff Carter’s put it best. One of Jeff’s friends son, a recent DePaul grad cannot find a job. He does not count in the unemployment statistics because he never had a job to lose. When the college grads do find a job, do you think they will demand as much $$$ as the Baby Boomer? A 57-year old friend of mine just took a job working in a bakery for $12 an hour. You cannot have inflation without rising wages.

    As for the Baby Boomers…they did their living ealry. They will work the rest of their lives. They did not save their money. They refinanced and went to Disney World. The Baby Boomers are sitting on big homes HOPING the price comes back. What do you get with BIG homes? BIG bills. The only thing the Baby Boomer has left are the retirement funds he invented 25 years ago. Capitulation on Wall Street will take care of that issue.

    It hasn’t even gotten ugly yet….

  • Dabobber

    If long bonds are a measure of future inflation the market is telling us something. Throw out the text books and really question,
    is the US economy and currency is in a deflationary or inflationary cycle. Plenty of money was printed in the 1930’s and the long term borrowing costs remained very low…1.5% or so…Japan’s model
    WW2 may have been the ultimate example of Keynesian economics. Where did the real money come for the War, not War bonds. I used the 1930’s because it was defaltionary much like today. Here is a good read. I am a big fan of Hugh Hendry(Eclectica Capital). He is quoted in the article.