US Economic, Regulatory and Banking History

Inflation v Deflation

Posted on Tuesday, October 19, 2010

Higher prices, one top Federal Reserve official believes, could lead us out of the economic slump.
The current problem, Chicago Fed President Charles Evans said in a speech Saturday, is that even though interest rates are near rock-bottom, people are tending to save money rather than spend it. The situation, called a "liquidity trap," means the economy resists the Fed's attempts to kick-start it: Even when money is cheap, people don't use it. But Evans proposed a solution.
In addition to a new round of quantitative easing, an asset-purchase strategy that would boost inflation and lower interest rates as more money enters the economy, the Fed could pursue "price-level targeting." Rather than aim for a specific level of inflation, a price-targeting program would, as the name suggests, aim for a specific level of prices and use any inflationary means necessary to get there.
In general, low interest rates have encouraged banks and other companies to borrow cheap money without spending it. U.S. corporations saw profits rise in the second quarter, despite declines in revenue, because many have been hoarding their cash -- a tendency that the New York Times noted won't do much good for the economy, since companies won't, for example, use that money to create jobs.
Promoting inflation via price-level targeting won't be popular, Evans predicted. "Central bankers and the public generally loathe the idea that even a temporarily higher inflation rate could be beneficial or be consistent with price stability over the longer term," he said, adding later that "Most critiques I have heard of this type of policy tool involve the risk of runaway inflation expectations or the loss of hard-earned credibility." Still, he said, despite the risks, the policy is at least worth considering.
Other Federal Reserve officials might not share Evans' views. St. Louis Fed president James Bullard told the Financial Times he was "sympathetic" to price-level targeting but added, "I don't think we're going to go in that direction any time soon."
Bank profits in recent months have also been boosted by the low interest rates, as HuffPost's Shahien Nasiripour reported in August. But again, lending dropped significantly, as confidence has remained low.

The current low rates have hurt savers, whose certificates of deposit and money market accounts are earning very little interest.

We are now at the crest of a decades-long cycle of declining interest rates. Chairman Bernanke fears a Japanese scenario, where the strong Yen has been pushing the Nikkei lower and exacerbating Japan's deflationary woes with a 15-year high against the US dollar.
So the Federal Reserve has been keeping interest rates artificially low. By aggressively purchasing Treasuries, they keep the short end of the yield curve very low. And because treasury debt is mostly short term, the scarcity of long term bonds makes their yields fall also. In that way the Fed has taken over the entire yield curve.

As a result, we are experiencing a new paradigm, where both inflation and deflation are prevalent.
This dichotomy is vexing. On one hand, markets are flashing warning signals of global deflation. Yields worldwide are falling, on Japanese, US, German and UK debt. Real estate is declining. Large institutions are still deleveraging as a result of the global financial crisis and consumers are cutting back in response to unemployment.
But markets are also responding to the vast increase in money supply, and the gusher of cheap money making its way throughout the economy. There is fear that the only way out from the debt levels we have is to inflate the currency. Many commodities are soaring. Gold is hitting new highs. Cotton is trading at over $1 per pound, for only the third time in history (incidentally, one of the other two instances was the Civil War).
With the national debt nearing 100 % of GDP, a deficit of 10% of GDP and with Federal spending that consumes 25% of GDP, government expenditures clearly have to be curtailed. But to cut the budget to 20% of GDP, where it was in the roaring '90's, we would need to eliminate $700 billion in annual spending. Even then, we will still be running a sizable deficit.
Since interest rates on existing debt are not negotiable, the only two components of the budget that have the potential for that size of cutbacks are entitlements and defense. That leaves our political leaders with an impossible choice.
Cutting the entitlement programs -- Medicare, Medicaid, Social Security-- is political suicide, and reducing defense expenditures at a time of war also seems parlous.
And hence the inflation expectations.
It is little wonder then that markets are concerned with the Federal Reserve's policies. Chairman Bernanke has pledged to engage in quantitative easing and promised to ensure economic recovery. The Fed has considerable clout, but still markets doubt whether they have the tools to catalyze a recovery, and whether such promises can be kept. The scale of the quantitative easing program is unprecedented. The Fed does not have an easy exit strategy and withdrawing its efforts will throw the economy into turmoil. And there is no consensus among Fed Governors on how to do it, either. Seven members recently argued that the Fed should not take drastic steps just yet.
But what is important to understand is which of these circumstances are already priced in. All the concerns described above have been well publicized. Bond yields have not been this low since the 1950's, and I believe they are pricing in a pessimistic outlook of either another recession or an extended period of tepid growth.
Market prices always reflect a certain point of view, and sometimes they are right. George Soros coined the term Reflexivity to describe this phenomenon, in which market participants influence reality with their views at the same time that they are using market signals to form their opinions.
Currently, people are anticipating weak economic results. But if the economy moves in a different direction, prices will make an appropriate adjustment. Interest rates are not likely to decline much from here, but if the economy turns out less dire than the current outlook, and especially if inflation becomes more pronounced, rates could easily rise substantially, sending bond prices tumbling down.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm.


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