We Shouldn't Be Concerned About Inflation? Really?

The Federal Reserve continues to argue that Americans should not be worried about inflation.  The recent bumps in the Consumer Price Index, we are told, are just temporary, being caused by special circumstances in the world, particularly affecting food and energy prices. 

The problem I have with this is that the information about inflation keeps getting worse…and not just in the United States. 

In the United States we see that the year-over-year rate of increase in the Consumer Price Index has established the following trend starting in November 2010: 1.4%; 1.7%; 2.2%; 2.7%; and, finally, in April 2011, 3.1%. 

And, the increases in the overall index also include increases in the major component of the index, the owner’s equivalent rent component of the housing price index, as follows over the same period of time: 0.2%; 0.3%; 0.5%; 0.6%; 0.8%; and finally, in April 2011, 0.9%.

These estimated “rental” numbers, obviously, help to keep the overall Consumer Price Index from rising too rapidly.    

But…everything is moving up!

And the world?

This morning the headlines read, “European Inflation Rises to Fastest in 2 ½ Years,” (http://www.bloomberg.com/news/2011-05-16/european-inflation-rises-to-fastest-in-2-1-2-years.html).  And, Jean-Claude Trichet, the President of the European Central Bank, is envisioning higher bank rates in the future.

In India, ”Wholesale Prices in India Rise 8.66 Percent in April From Year Earlier,” (http://www.bloomberg.com/news/2011-05-16/wholesale-prices-in-india-rise-8-66-percent-in-april-from-year-earlier.html), and, the Indian government is seeking higher interest rates.

In China (http://www.bloomberg.com/news/2011-05-16/china-stock-index-futures-fall-on-inflation-greece-concerns.html) the Chinese government has raised interest rates and increased the required reserves in the banking system.

Meanwhile, the Federal Reserve System in the United States continues to flood the banking system with excess reserves, 50 percent of these reserves ending up as cash assets in foreign-related financial institutions within the United States (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s).  The Fed seems to be underwriting the “carry trade” throughout the world.

How can inflation not be in our future?

Commercial banks in the United States are sitting on $1.6 trillion in cash assets…excess reserves, if you will. 

The Federal Reserve is pushing to help the Obama Administration reduce the unemployment rate!  And, the Fed does not seem to want to back off of this objective.

The Fed is encouraged because business loans, commercial and industrial loans, at the biggest 25 commercial banks in the United States finally seem to be increasing giving some hope that businesses will start hiring people at a faster rate in the future. (See my post from yesterday, mentioned above.)  So, monetary policy seems to be starting to work.

But, the momentum of economies is slow to gain speed and this momentum is slow to contain once it has begun. 

The fear in the developing countries is that the economic momentum is “too hot” and needs to be brought down.

The fear in the developed countries is that stagflation is going to take over…the momentum will take place in prices while inflation will not be combated to any degree because of the employment concerns. (See “Threat of Stagflation Rears Its Head”: http://www.ft.com/intl/cms/s/0/21d6545c-7d89-11e0-b418-00144feabdc0.html#axzz1MWF5W9Ov.)

We shouldn’t be concerned with inflation?

I don’t think the American government in its current state of mind can live without credit inflation.  The habit is too imbedded in the political psyche.  

The federal government has underwritten credit inflation for the past fifty years.  As a consequence, the public debt of the United States government has increased at a compound rate of growth of about 8 percent over the last fifty years.  Credit market debt has risen by more than 10 percent per year over the same period of time.  These rates of increase are not slowing.

Inflation will come in one way or another because there is no end in sight of the current attitudes toward debt creation.

Almost One-Half of Cash Assets in Commercial Banks are Held by Foreign-Related Institutions

Check this out: on April 6, 2011, Commercial Bank Reserve Balances with Federal Reserve Banks totaled $1.503 trillion (Federal Reserve Release H.4.1); for the two weeks ending April 6, 2011, Excess Reserves at depository institutions in the United States averaged $1.431 trillion (Federal Reserve Release H.3); and on March 30, 2011 Cash Assets held by Commercial Banks in the United States were $1.558 trillion (Federal Reserve Release H.8).

All these measures of excess cash in the commercial banking system seem to center around $1.5 trillion.

The Federal Reserve also reports that on March 30, 2011 the cash assets held by Foreign-Related (banking) Institutions in the United States totaled $702 billion or right at 45 percent of the cash assets held by commercial banks in the United States on that date!

The Federal Reserve policy of Quantitative Easing (QE2) is supposed to spur on bank lending which, hopefully, will contribute to a faster growing economy and lower unemployment.

The published figures indicate that a very large portion of the funds the Fed is injecting into the economy is going into the “carry trade” and contributing to the spread of American liquidity throughout the world.

One rationale that has been given for the policy that the Fed has been following is that when commercial banks aren’t lending (that is, there is a liquidity trap), the Federal Reserve needs to inject as much liquidity into the banking system as possible until the banks begin to lend again. This is the essence of quantitative easing.

This rationale was developed by people who studied the history of the Great Depression. Milton Friedman contended that a central bank should follow such a policy when faced with a banking system that was not expanding the money stock. Professor Ben Bernanke also suggested that such a policy be followed.

However, in the current environment, there are two things that seem to be different from that earlier period. The first relates to the international mobility of capital: in the period around the 1930s nations did not support the free flow of capital throughout the world because the international financial system was based on the gold standard and foreign exchange rates fixed in terms of the price of gold.

Thus, with international capital flows constrained, it was argued that a country could keep a fixed foreign-exchange rate for its currency and conduct its economic policy independently of other countries, thereby allowing the country to focus on reducing unemployment to more acceptable levels. The policy prescription advocated by Friedman…and Bernanke…could, therefore, be followed within such a world without major foreign repercussions.

This is not the situation that exists now. Capital flows freely throughout the world.

The second factor is that there was no designated national currency that was designated as the “reserve currency” of the world. Thus, currencies were seen as either fixed in value or were allowed to freely float in foreign exchange markets. (I am not dealing with “dirty” floats and so forth at this time because they are related to currencies that are not designated as “reserve” currencies.)

And, since the United States dollar serves as the reserve currency of the world and, because of this, is the default currency when there is a “flight to quality” in world financial markets, the value of the dollar does not fall to the level that is needed to allow the Federal Reserve to conduct its monetary policy independently of all other nations.

The consequence is that the Federal Reserve is inflating the whole world!

It is great for the currency of a country to be the reserve currency of the world. However, being the reserve currency of the world carries with it responsibilities.

One of these responsibilities is that the United States cannot conduct its monetary policy independently of everyone else!

The value of the United States dollar is higher than it would be if it were not the reserve currency of the world. As a consequence, the behavior of the value of the United States dollar does not act exactly as if it were determined if it were a freely floating currency in the foreign exchange markets.

Therefore, the monetary policy of the Federal Reserve, given the free-flow of capital throughout the world, cannot be conducted in isolation.

We are seeing the result of this situation right before our eyes.

The Federal Reserve is pumping money like crazy into the commercial banking system. And, 45 percent of the money is ending up in foreign-related financial institutions.

This, I believe, is not what the Federal Reserve wanted.

This, I believe, is not what the people of the United States wants.

And, I believe, that this is not really what the rest of the world wants.

Still, QE2 continues, unabated.

Meanwhile Back in Europe

Europe has been relatively quiet recently, except for occasional bursts of news coming from or about German Chancellor Angela Merkel. The euro has been relatively strong: it has risen a little over 7% against the U. S. Dollar since the beginning of the year. Relative interest rate spreads on sovereign debt in the eurozone have remained relatively steady.

However, there still remains a lot of work to do in Europe and with all the disagreements among the leaders as well as everything else happening in the world the bailouts and other financial relationships are just not getting done. Let’s just say one shouldn’t get too comfortable in this quiet.

Something concrete for the near term: the European banks are starting their second round of stress tests this weekend. This second round is supposed to be “sufficiently stringent” this time.
We’ll see! They sure weren’t very “stringent” the first time around.

The question is whether or not confidence in the European banking and financial system can be returned so that other matters can be dealt with.

Beyond that, meetings will continue among the leaders of the European nations. Whether or not they can craft a bailout plan is still up in the air. In addition, the process for how the nations are to conduct their fiscal affairs also needs to be decided upon. Problems will still linger until they achieve some more coordination in budget-setting…hard for sovereign nations to give up.

But, speaking of sovereign nations, the problem of sovereign debt still overhangs the financial
markets.

Kenneth Rogoff, who co-authored the book “This Time is Different”, stated in Berlin yesterday that Greece and Ireland will need to restructure their debts. (See http://www.bloomberg.com/news/2011-03-02/rogoff-says-debt-restructuring-inevitable-in-greece-ireland.html.)

Rogoff also added that Spain and Portugal may be forced to do the same thing.

Bondholders, he argued, may have to take losses as large as 40 percent of their holdings of this sovereign debt.

“If Spain were to have a restructuring of central government debt, I don’t think it would end there” said Rogoff, “Spain is just too big.” Other countries facing a restructuring might then include Belgium and more.

But, this is not all!

Europe is facing more inflation. For one, the United Nations announced that world food prices rose to a record level in February and may exceed this level over the next few months. Furthermore, the turmoil in the Middle East is not easing price pressures as the pressure on oil prices increases.

The new element in this latter situation is that Asian countries like China and India now have the wherewithal to hedge against the unrest in the Middle East by shoring up their oil reserves. Even as these oil importing countries add to world demand as their economies grow they also have the financial resources to stockpile reserves in a way that presents a new dynamic to global markets.

And, the money is there for this process to continue worldwide: “What can best be described as ‘the unintended consequences of quantitative easing’ (on the part of the Federal Reserve in the United States) have played a major role. With many emerging nations addicted to their dollar currency pegs, easy US monetary policy finds its way into every nook and cranny of the global economy.” This written by Stephen King, group chief economist at HSBC in “Central Banks Risk Wrecking Recovery” (http://www.ft.com/cms/s/0/cab418ce-44c3-11e0-a8c6-00144feab49a.html#axzz1FMM69iWr).

These “unintended consequences” will continue to plague commodity markets worldwide. Nations and investors have the dollars or the access to dollars to keep these prices rising and this access will not go away soon.

So what about an increase in interest rates?

Well, for the twenty-second month the European Central Bank (ECB) held its main interest rate steady at 1%. Jean-Claude Trichet, ECB president, stated that inflation was a worry and although the rate was held at the current level for the time being, it certainly could rise in April.

Inflation in the eurozone was 2.4% in February, above the target limit of the ECB which is 2.0%.

Rising interest rates can only put more pressure on the governments in Europe, just as rising inflation rates can increase calls from Germany for greater government discipline in fiscal affairs.

“Back in Europe” things are still unsettled. As to the undercurrents going on above look out for the following:

First, the bank stress tests will show little or nothing and will give financial markets very little additional confidence in the European banking system;

Second, no agreements will be reached within the European Union until some of the nations within the EU restructure their debt and the pain of the fiscal situation will then become very obvious;

Third, this restructuring of debt and the continued increase in inflation will put Merkel and Germany in an even stronger position to get a more conservative process of fiscal oversight included in any package that the EU agrees upon;

Fourth, the ECB will hold off an increase in its main interest rate for as long as it can so that a rise in the rate will not serve as a cause of the debt restructuring and will allow the leaders in the EU to craft a new relationship in as orderly fashion as possible.

Inflation will continue to rise in Europe and in the rest of the world and this will put central banks under greater and greater pressure to begin to combat the inflation. Politically, this is still going to be very hard because of the mediocre economic recovery now taking place and the political unrest being caused by governmental restructurings. But, that is another story.

The Obama Debt Machine

My estimate for the cumulative deficit over the next 10 years before the Obama budget was announced this week: in excess of $15 trillion.

My estimate for the cumulative deficit over the next 10 years after the Obama budget was announced this week: in excess of $15 trillion.

I see no leadership coming from this administration (or the Congress) to achieve anything different in the future. There is no evidence of the will to take leadership on the United States economic ship.

We have arrived at this position through the actions of both Republicans and Democrats. There is no evidence that this condition will change in the near future.

Everything is the same, with one exception: we are heading full steam into the 2012 presidential election.

Our history: We have had 50 years of credit inflation that has brought us to this position.

Forecast: credit inflation will continue for the foreseeable future.

Housing and the Economic Expansion

The Great Recession is over. Remember, the recession ended in June 2009 getting close to two years ago.

To many, it sure doesn’t feel like it. Since the second quarter of 2009, over the last six quarters, real GDP has grown by 4.5%. The average year-over-year growth rate for the five quarters since the recession ended is 2.3%. This is way below historical experience.

The reason: housing usually leads the economy into a recession, and, housing usually leads the economy out of the recession.

Not so this time.

And, this is why we are in the mess we are in. Housing is not going to rebound any time soon.

For one thing, banks and thrift institutions (what are they?) really don’t want to provide financing for mortgages. They really don’t want to hold mortgages. For another, the mess with Fannie Mae and Freddie Mac is so uncertain and confused and uncomfortable that they want to have as little to do with mortgages as possible.

In order to understand this I had to go through the mortgage process myself last year. I have no problem getting a loan. I went to the bank where I do most of my business and asked about getting a loan. Sure, they said, and arranged a meeting with the mortgage banker they do business with who approved my loan and all of a sudden my mortgage is with Fannie Mae and I am making payments to the mortgage servicing subsidiary of a major bank somewhere far to the west of Philadelphia. Never in my life have I had a mortgage in the hands of Fannie Mae. Oh, well…

This is, to me, the paradigm of the banking industry. Banks, especially smaller banks, don’t want to hold mortgages on their balance sheets. And, this is just what we wanted it. In the late 1960s and early 1970s when I was in Washington, D. C. and we were creating the mortgage-backed security the idea was to get mortgages out of the commercial banks and thrift institutions and into the hands pension funds and insurance companies who needed long-term assets. Then the depository institutions could lend more.

Why did we create the mortgage-backed security? So, politicians could get re-elected. If more families in America could own their own home through things the government did, then they would be more likely to vote back into office the people that were responsible for their owning their own home.

Likewise with lower income housing, after all, the number one job of politicians is to get re-elected.

So, the United States government got into the business of inflating the housing sector so that
more-and-more American families could own their own home.

How successful was this? Well, in the early 1970s, no mortgages were traded on any capital market in the world. Michael Lewis’ incredible book, “Liar’s Poker”, related to the middle- to late-1980s, and was a large part about the market for mortgage-backed securities which had become the largest component of the capital markets. And, as they say, the rest is history.

But, housing was always the fulcrum on which economic cycles turned. The basic reason was that housing construction could easily be started up and stopped and started up again. The longest post-World War II recessions (before the Great Recession) were one year and 4 months in length and there were only two of them. In order to slow down economic growth and fight inflation, the Federal Reserve would raise interest rates and this would cause mortgage lending to slow down or stop for a time. After sufficient time the Federal Reserve would lower rates once again, mortgage lending would pick up and economic growth would expand once more.

Business lending always lagged the movements in mortgage lending.

It seems as if mortgage lending and housing construction has tapped out. The credit inflation of the housing industry of the last sixty years cause sufficient dislocations that it is going to take a while for the United States economy to re-structure so that the housing industry can pick up once again.

Financial institutions are still facing major, major problems related to the housing industry, not counting the major problems relating to commercial real estate. Commercial banks are slowly accepting the fact that they are going to have to buy back many troubled mortgages, especially mortgages that were sold to Fannie Mae and Freddie Mac. Bank of America has paid back a little, but more is expected. JPMorgan Chase also has a large exposure. What is the hole? Standard & Poor’s has estimated that banks will have to buy back around $60 billion in bad mortgage loans which they sold to others. Some estimates place this total as high as $150 billion. (http://dealbook.nytimes.com/2011/02/09/banks-could-face-60-billion-tab-on-bad-loans/?ref=todayspaper)

In addition to this, the latest statistics indicate that more than one in four mortgages outstanding are underwater, that is, these mortgages are on homes that have a market value less than the amount owed on the mortgage. Homeowners facing this situation are still walking away from their obligations. Who picks up the difference? And, housing prices still remain weak in many markets within the nation.

About one in four individuals in America are either unemployed or under-employed. Savings can only go so far in keeping up payments on the home mortgage. And, 30 states have run out of money in their unemployment trust funds and are borrowing from the United State government to cover the shortfall. How long is this going to continue to be covered?

Manufacturing businesses are only running at three-fourths of capacity, up slightly from historical lows. With so much idle capacity, businesses are not interested in purchasing more capital and hiring more workers to create jobs and incomes. Purchasing seems to be very skewed…basics and luxuries…and computers. This is not very encouraging for a near term pickup.

With little or no housing pickup, expectations for a strong business pickup are pretty low. And, the Fed’s QE2 is not going to have a major impact on the reduction in unemployment or under-employment!

People have one way out of this dilemma in the short run. Inflation!

Inflation may not put the people back into a job, but it can cause housing prices to rise and this can buy them out of the underwater situation. Still, commercial banks, I believe, want to have as little to do with holding mortgages as possible. And, if they originate, or get their mortgage banking friends to originate mortgages, who are they going to sell them to?

Even so, all this will just postpone the housing problem until another time, just like we have done for the last sixty years. We just see high levels of under-employment, low levels of capacity utilization, high amounts of inflation, more debt and more debt, and where does this end?

The Great Recession is over. However, the Great Recovery is nowhere in sight.

Inflationary Expectations, the Dollar, and the 10-year Government Bond Yield

On Saturday, Allan Meltzer made the statement that “Inflation is coming.” Like the 1970s, we are in for another bout of high unemployment and inflation, which “flummoxed” the Federal Reserve’s policy committee and created a situation in which ”inflation and unemployment rose together throughout the decade.” (http://professional.wsj.com/article/SB10001424052748704709304576124033729197172.html?mod=ITP_opinion_0&mg=reno-wsj)

The market evidence for this?

“Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness.”

The above chart shows that value of the United States dollar relative to the Euro. As the line rises the dollar weakens. In the early part of 2010, the Eurozone seemed to fall apart as the fiscal problems faced by sovereign governments created a financial collapse. The Euro declined against other currencies in the world.

By the summer of 2010, some quiet had returned to Europe and the Euro began to strengthen again against the dollar moderating late in the season around$1.27. However in late August 2010, Fed Chairman Ben Bernanke announced that QE2 was on the horizon and, as can be seen, the value of the dollar fell dramatically reaching the $1.40 neighborhood in November.

Although the value of the dollar rose again toward the end of the year, it again appears to be under siege as the dollar has fallen back into the $1.36-$1.37 range. So, in spite of its weakness, the value of the United States dollar seems to be losing ground relative to the Euro.

The key to this behavior Meltzer believes is the expectation of inflation. It is assumed by many that inflationary expectations get built into interest rates. I have just written on the current situation, the recent changes in inflationary expectations and the possible future movement in interest rates. See my post, “Long-Term Treasury Yields and Inflationary Expectations.” (http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations)

Here we have a chart the yield on 10-year Treasury securities. Note the decline in the yield that took place in the early part of 2010 to the fall. Many argue that this decline was due to a flight-to-quality as the investors left the sovereign debt of Eurozone countries and brought their money to invest in US Treasury securities.

Whereas the announcement of the coming of QE2 came in late August (and rates bounced up on the very next trading day after the Bernanke speech), the actual plan of action for QE2 was released in October and the Fed began conducting the QE2 in November. As can be seen in the above chart, the yield on 10-year treasuries has risen ever since. The last day in this chart is February 4. On February 8, the yield on the 10-year treasury security closed over 3.70 percent, a rise of 150 basis points since the late August date of Bernanke’s speech.

The argument can be made that participants in the financial markets are so sensitive to the possibility for future inflation that on the very next market trading day following the Bernanke statement, inflationary expectations began to build in the bond markets. And, the buildup of these inflationary expectations was also experienced in the market for the United States dollar and the dollar traded weaker even to the Euro even though the Eurozone was experiencing many fiscal and financial problems.
One can see this more clearly in tracing the value of the dollar indexed against major currencies. Here it is obvious that the dollar is trading at the lows reached over the past year and is even threatening the post- World War II lows reached in the summer of 2008.

It appears as if many investors in world financial markets agree with Allan Meltzer that, in fact, “Inflation is coming.” It is just the United States government that doesn’t see this.

Long-Term Treasury Yields and Inflationary Expectations

The yield on the 10-year Treasury bond closed at 3.48 percent yesterday. Just a little over five months ago the yield on the 10-year Treasury bond was at 2.48 percent, a full 100 basis points lower than the current yield. What’s happening and where are we going?


Two extraordinary factors are impacting Treasury yields at the present time and have been there for quite some time now. The first of these is the effect that the quantitative easing of the Federal Reserve is having on market rates. The second is the “flight to quality” that has kept the yields on Treasury securities below what they otherwise might be. How do I account for these two factors?

Well, first I start out with a “rough” estimate of the real rate of interest. The base figure that I have used for years has been 3.0 percent.

(I just found out this morning that this is similar to what my former colleague Jeremy Siegel,
Professor of Finance at the Wharton School, UPENN, uses: http://www.ft.com/cms/s/0/00d6f8d0-2ec7-11e0-9877-00144feabdc0.html#axzz1Chh2pOYC.)

This figure, the 3 percent estimate is a “before-the-fact” estimate and therefore is a long term expectation. An “after-the-fact” estimate is often made by taking the nominal rate of interest, say the roughly 3.5 percent mentioned above and then subtracting actual inflation from this figure. This is “after-the-fact” because the numbers used to calculate the real rate have already occurred.

The 3 percent estimate is important because it can be compared to another, so-called, real rate of interest, the yield on inflation-protected securities, called TIPS. Yesterday, the yield on 10-year inflation-protected securities was 1.04 percent at the closing, substantially below the 3 percent estimate.

Siegel, I believe rightly, calls our attention to this discrepancy because he believes that the current yield on inflation-protected securities must rise toward the higher number and this will mean that the holders of these securities may suffer substantial capital losses on the securities because the price of the securities must decline to allow the yield to rise.



Investors are not fully aware that this decline might happen in this area of the bond market.

The difference between the current market yield on these securities and the “before-the-fact” estimate of the real rate of interest represents the impact that the Fed’s quantitative easing along with investor’s “flight-to-quality” is having on the current market yields. If this is true then the nominal bond yields in the market are roughly 200 basis points below where they would be without the Fed’s actions as well as including the international flight to safe United States Treasury issues.



If this is the case then we could argue that the yield on the 10-year Treasury security should be around 5.50 percent rather than 3.50 percent.

If this is the case then the longer-term “inflationary expectations” that investors have built into market yields would be around 2.5 percent.



The question then becomes, is this estimate of inflationary expectations “in the ball park”?
I like to look at the year-over-year rate of change of the GDP price deflator as my estimate of the rate of inflation because I have less concern that this figure is being “messed” with than the more popular Consumer Price Index. Looking at this measure of actual inflation we see that inflation does seem to be picking up.



In this chart we see that the rate of inflation is picking up and is now just below 1.5 percent. We can note that once inflation starts to pick up, it does not reverse itself in the near term. Furthermore, looking at the performance of inflation over the past ten years, an inflation rate of 2.5 percent is not unreasonable for a moderately growing United States economy. And, remember, this 2.5 percent can be interpreted as the compound rate of inflation over the next 10 years, a period far beyond the inflation that might be experienced over the next year or so.

Added to this is the fact that inflation is picking up, not only in the developed countries in the world, but also in the emerging countries. Inflation in the Eurozone is running a little above 2.0 percent, in the UK, a little under 4.0 percent, and in China and India, the rate of inflation is now in excess of 5.0 percent. Thus the trend in the world is for increasing rates of inflation.



My rough estimate that the yield on the 10-year Treasury bond should be around 5.50 percent in 2011 is slightly above the forecast I presented earlier. (See “Long-Term Treasury Yields in 2011: http://seekingalpha.com/article/243018-long-term-treasury-yields-in-2011.) The reason for this change, I believe, is that investors, world wide, are believeing that inflation is becoming a bigger problem than earlier expected. The European Central Bank has ceased its special purchase program of securities because of the rising concern over price increses. The Bank of England has experience similar concerns. The only central bank that does not seem concerned yet is the Federal Reserve.



And, of course, my forecast assumes that the Federal Reserve will, at some point this year, back off from quantitative easing.



But, why should we expect the Federal Reserve to back off from QE2 any time soon? Chairman Bernanke has been late on every shift in monetary policy since he has been a member of the Board of Governors. Why should we expect anything different this time?

Where is the Inflation? All Around!

Ronald McKinnon writes in the Wall Street Journal this morning, “The U. S. is a sovereign country that has the right to follow its own monetary policy. By an accident of history, however, since 1945, it is also the center of the world dollar standard...So the choice of monetary policy by the Federal Reserve can strongly affect its neighbors for better or worse.” (http://professional.wsj.com/article/SB10001424052748704405704576064252782421930.html?mod=ITP_opinion_0&mg=reno-wsj0

Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in Santiago, Chile yesterday: ”I believe we have come to expect too much from monetary policy.”

In terms of what monetary policy can do, we know that one of the fundamental lessons of economics is that “Inflation is, everywhere, at every time, a monetary phenomenon.”

Monetary policy cannot produce full employment, or retract over-investment, or fund state and municipal government pension funds that have been under-funded for years. Monetary policy cannot educate or train people for today’s jobs.

Monetary policy cannot make commercial banks solvent that have made bad loans or investments.

McKinnon asks, “What do the years 1971, 2003, and 2010 have in common? In each year, low U. S. Interest rates and the expectation of dollar depreciation led to massive ‘hot money’ outflows from the U. S. and world-wide inflation. And, in all three cases, foreign central banks intervened heavily to buy dollars to prevent their currencies from appreciating.”

But, the U. S. is a sovereign country that has the right to follow its own monetary policy...

And, how is this happening?

First, money flows into auction markets such as commodity markets or foreign exchange markets. (http://seekingalpha.com/article/246657-emerging-markets-the-bubbles-are-real)

Second, funds begin to flow into other areas of non-United States economies. Consumer price indexes have been rising in many of the emerging countries around the world. In particular, China, Brazil, India, and Indonesia have experience increases in their price indexes of more than 5% in 2010. In both the Eurozone and in England, the central banks are having to deal with the problem that, despite slow economic recovery and reductions in government spending due to the sovereign debt crisis, recorded inflation is exceeding their long run inflation targets.

Only after some lag time takes place does the inflationary pressures get built up within the United States. This lag time may be as much as five years, especially given the structural problems that exist in the United States economy. (http://seekingalpha.com/article/246404-why-debt-is-going-to-continue-to-be-problem-for-u-s) This is the historical experience.

Notice, that in two out of the three dates that McKinnon highlights, Ben Bernanke played a prominent role. Bernanke was a board member of the Federal Reserve during the 2003 time period and helped to compose the justification for the Fed’s policy at that time. Of course, Bernanke is currently the Chairman of the Board of Governors.

One must also remember that it was Chairman Bernanke who continued to fight inflationary pressures into the late summer of 2007 before the Fed totally had to reverse their policy stance when Bear Stearns declared bankruptcy. (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson)

Mr. Bernanke does not have a very good record in judging when he, and the Fed, are heading in the wrong direction. Zero for three is not a very good batting average!

The consequences of inappropriate economic policy work themselves out slowly, but they also inevitably work themselves out. This is the message in the research of Ken Rogoff and Carmine Reinhart. (http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff)

Here we need to quote another fundamental lesson of economics: monetary policy works with long and variable lags.

Monetary policy takes a long time to work itself out throughout the economy. And, the effects of monetary policy cannot be reversed quickly.

One of the reasons why some economists have argued that monetary policy should be conducted according to “rules” rather than “authority” is that, historically, the track-record of policy makers is not so “hot.” And leaders that have a batting-record of zero for three do not add anything to the confidence level.

Where is the inflation?

It can be found throughout the world. The United States is “the center of the world dollar standard.” What the United States does in terms of monetary policy affects the world! And, what is happening in the world, sooner or later, also affects the United States. McKinnon is arguing that this is the historical record.

Long-term Bond Yields and QE2

One of the fundamental things I learned when working in the Federal Reserve System and in running financial institutions was that the Federal Reserve could only temporarily lower long term interest rates.

In attempting to achieve a goal of lowering these rates, the yield on long-term Treasury securities would initially dip below its previous level and then rise to a point where it was above the previous level. The moral of this market behavior was that attempts to keep long term interest rates lower than the market desired only ended up causing the rates to go up as the market adjusted to the efforts of the central bank.

In my professional career I have not observed anything that would lead me to change this viewpoint.

Yet, supposedly, the QE2 efforts of the Federal Reserve are aimed at reducing the yield on long-term Treasury securities so as to encourage a more robust recovery of the economy. The argument given is that there is little or no indication that inflation will pick up because, if anything, the probability that we might enter into a period of deflation is high enough to be of concern.

As recorded in my post yesterday, I believe that on the subject of inflation/deflation, Ben Bernanke is a lagging indicator. He always seems to be behind what is happening. (See “The Fed: Bubble, Bubble Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.)

Let me start from where I am. First, the United States economy IS recovering. However, this recovery is going to be a very slow one because of all the re-structuring that needs to be done within the economy of the United States. We have considerable under-employment with one out of every four individuals of working age being under-employed. We have a capital structure in which a lot of capital is not being used: current capacity utilization is around 75% and the previous peak “high” was only about 81%. We have built too many houses and there seems to have been too much development of commercial properties. There is still too much debt outstanding: more deleveraging needs to take place. And, this doesn’t even come close to touching the needs of our educational system. (See “Top Test Scores from Shangshai Stun Educators,” http://www.nytimes.com/2010/12/07/education/07education.html?ref=education.) And, so on.

I just do not believe that monetary stimulus, or, for that matter, further fiscal stimulus is going to achieve much faster economic growth.

The financial system is still fragile and this, I have argued is the real reason for the Fed’s attempt to flood the world with liquidity. Banks, other than the largest 25 banks, are still extremely distressed. State and local governments face huge fiscal problems. And, the federal government is going to post $15-$18 trillion in new debt over the next ten years given the current budgetary posture. Financial markets must be kept calm so that the FDIC and others can work off insolvent banks; where pension accounting in government can be brought into line; and assets values can be written down throughout the economy.

Let me reiterate: the economic recovery is progressing.

And, what about inflation?

According to the implicit price deflator of Gross Domestic Product, inflation was running at about a one percent year-over-year annual rate in the third quarter of this year. I prefer this measure of inflation as opposed to the Consumer Price Index (CPI) because of all the expert “fussing” with this latter measure over the past 15 years. Also, I do not really trust an indicator that has a large component relating to the rental price of owner-occupied housing that is estimated and has been shown to have substantial biases.

As can be seen from this chart, the year-over-year rate of change in prices did not turn negative during the Great Recession and seems to be on a relatively steady upward movement. It is my belief that the inflation shown in the GDP Implicit Price Deflator will continue to rise, but not explosively.

That is, the economy will continue to grow, but only modestly over the near term. And, I believe that the longer-term trend in prices in the United States economy is up. Furthermore, I believe that the longer-term trend in the value of the dollar is down.

In terms of the last forecast I believe that the value of the dollar will continue to decline in world markets over time in spite of the best efforts of Europe to “prop up” the dollar through the absence of leadership and guts that seems to prevail in the halls of the European Union.

Now, back to bond yields. Within the scenario I have described above, I really cannot see how the Federal Reserve, through its QE2 efforts, can keep long-term Treasury yields down. I guess my major question becomes, is this really the goal of the Federal Reserve? Or, are the statements coming out of the Federal Reserve a diversion to keep people from looking too deeply into the continuing problems of the banking system, and of the state and local governments, and asset values? Are the efforts of the Federal Reserve just a holding action while the value of assets, those of banks, those of state and local governments, those of home owners, and those of businesses, are written down?

To me, long-term bond yields should rise over time. I just can’t see how the Fed can keep them down.

What is most disturbing in all of this to me is the fact that the Chairman of the Board of Governors of the Federal Reserve System has become the primary spokesperson of the Obama administration. Tim Gaithner has failed in that role; Christina Romer has failed in that role: and Larry Summers has failed in that role. Now, Ben Bernanke has become the voice of Obama on economic affairs. How sad!!!

Is the United States Making the Emerging Nations Stronger?

Why is the rate of inflation so low in the United States when the government has pumped huge amounts of debt into the country and the Federal Reserve has loaded the financial system with large amounts of liquidity?

The same question was asked in the 1990s. Where was the United States inflation?

The answer for the 1990s…and for the present time period…is that the United States has exported inflation to the rest of the world…more specifically…Asia. As the accompanying chart shows, inflation seems to be heading up in Asia…as it is also heading up in many other emerging nations.

As reported in the LEX column of the Financial Times yesterday, global inflation has seemingly bifurcated. In the developed countries the current inflation rate is below 2 percent (Australia and the UK are exceptions). Morgan Stanley expects a 1.5 percent rate of growth for the wealthier countries in 2010. “By contrast, the emerging market inflation rate is about three times higher—expected at 5.4 percent in 2010…” (http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK)

The post-financial crisis stimulus is now feeding the inflation in the emerging countries. “A significant portion of the river of cheap money flowed into commodity markets. The initial price recovery caused no problems, but the trend now threatens to create a vicious circle.”

There is also the “carry trade” which takes United States dollars throughout the world seeking higher interest rates. This flow is certainly not insignificant.

In these days, it seems like it is very difficult to contain the international flows of capital. Maybe policy makers need to give this a little more weight in their policy discussions.

There is an argument that central banks, in some Asian countries, kept their interest rates “appropriately low” over the past year or so because of “concerns about the strength in their developed-market trading partners” especially the United States. Now, with inflation threatening to get out-of-hand in the emerging nations, these same central banks are faced with the need to raise their domestic interest rates higher and higher. (See “Emerging Wild Card: Inflation”: http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK.)

The article continues: “One conundrum for investors is how more aggressive tightening would play out in the currency markets. Most investors have been operating on the assumption that with the Fed keeping interest rates at zero for the foreseeable future, any moves by emerging-market countries to raise interest rates would attract even more money from yield-hungry investors.”

This seems to reflect a cumulative problem. By keeping interest rates low in the United States, dollars are flowing out into the rest of the world. This out-flow is threatening to bring about greater amounts of inflation in the emerging nations of the world. In order to combat this rising level of inflation, the central banks in emerging nations are raising interest rates. But, in raising interest rates, more United States dollars flow to these emerging nations.

And the flow of money into dollars from Europe as a “safe haven” has kept the value of the dollar stronger than it otherwise would be in such a situation which just enhances the return to investors from moving into the interest rates in the emerging countries.

So, the Federal Reserve continues to inject large amounts of reserves into the banking system, hoping to get the United States economy going again. But, individuals, families, and small businesses do not seem to want to be borrowing. Only large, healthy companies seem to be borrowing and piling up cash reserves. The money the Fed is printing seems to be going off-shore.

Therefore, instead of stimulating the United States economy, the Federal Reserve seems to be stimulating the emerging countries of the world. The two results of this seem to be that the United States is not getting stronger, but it is helping the rest of the world to get relatively stronger. The rest of the world needs to keep inflation under control, but the emerging nations feel the relative shift in power within the world and are taking more and more advantage of this increased power. See reports on the recent G-20 meeting. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)
Only strong, self-disciplined countries come out on top. Right now, the United States is anything but self-disciplined and it is finding that its relative strength is slipping away. The unfortunate thing is that in its lack of self-discipline, the United States is feeding the rising relative strength of the emerging nations in the world. This is our fault, not the fault of other nations within the world.

Economic Recovery?

The front page of the New York Times reads, “Why So Glum? Numbers Point to a Recovery.” (http://www.nytimes.com/2010/04/09/business/09norris.html?hp) The economic recovery is at hand, yet, to many, even to many economists, something seems to be missing.

Unemployment remains high, but it is a lagging indicator. Consumer debt remains high and home foreclosures and personal bankruptcies continue to stay near record levels, but these tend to be lagging indicators. State and Local governments are on the edge, apparently faced with becoming the “next Greece.” (For example, this morning see “Los Angeles Faces Threat of Insolvency”, http://online.wsj.com/article/SB20001424052702304830104575172250422355156.html#mod=todays_us_page_one, and “Next ‘Big Crisis’ Is Unfolding in Muni-Bond Market”, http://www.bloomberg.com/apps/news?pid=20601039&sid=aKj_LXH6zUrw.) But, these problems are related to the condition of the consumer and hence will not recover until the consumer recovers. Commercial banks are not lending, small businesses are not getting bank loans, and there are still concerns about the value of bank assets and the impending loan problems.

Floyd Norris, in his New York Times article, speaks about slow economic recoveries and attempts to put the current situation within the context of other post-World War II recessions. Within this context, he argues, the prospects for the current recovery are not that bad. When the economy is turning around, current data tend to be revised as more information becomes available and the recoveries, historically, appear to be “less slow” than they were during the time they were actually being experienced.

I believe that Norris is correct in his interpretation of where the United States economy is at the present time and how the data we are now receiving compares with the data relating to previous
recoveries.

What this misses, as I have tried to present over the past six-to-nine months, is that there are other factors at play in the economic developments of the past fifty years and this has created a situation that is not favorable to a strong economic performance in upcoming years…unless some things change.

One of those changes that are necessary relates to the inflationary bias of our government’s monetary and fiscal policies. As I have mentioned many, many times before, inflation is not helpful over the longer run and, in fact, over the longer run tend to hurt the very people the inflationary bias is aimed to help. The fact that the purchasing power of a dollar has declined by over 80% in the last fifty years has left the American economy is a very weak position. Long-term inflation has had an impact on the economy.

For one, inflation is supposed to help existing manufacturing industries. Yet, we have seen that over the past fifty years, the capacity utilization of United States industry has continuously declined with each peak reached in a subsequent period of economic recovery lying below the level of the previous peak. (See my post “The Trouble with Recovery,” http://seekingalpha.com/article/192713-the-trouble-with-recovery.)

Inflation is supposed to help labor, yet the level of the under-employed has risen almost constantly during the last fifty years. As capacity utilization has declined, the “mainstream” laborer has found him- or her-self less and less trained to do something outside “mainstream” industry. Hence, the growing number of those that don’t “fit” into the twenty-first century industrial structure. It will be very difficult to put these people back-to-work on a full time basis.

The economy of the past fifty years has also relied on the strength of construction, especially the construction of houses. This area has received special attention in that the government has created many, many financially innovative ways to support this industry which has led to an inflation in real estate prices that has out-stripped those in other areas of the economy.

A consequence of this has been that most personal saving over the past fifty years was tied up in the value of a person’s home. People saved by investing in a home and then watching the value of the house continue to appreciate. This appreciation of home prices also allowed their owners the opportunity to borrow against the increased value of the house to maintain higher and higher living standards. Now much of this “wealth” has been destroyed.

And, the inflationary bias has led to a hurricane of financial innovation. The creation of debt and financial innovation thrive in an inflationary environment. The last fifty years has been a treasure-trove for those in the financial industry and the financial innovation that has resulted exceeds that of any period in the history of human-kind. The economy may seem unbalanced with the growth of the finance industries relative to the manufacturing industries, but that is what you get when you have fifty years of consumer and asset price inflation.

The theoretical underpinnings of the policies that have resulted in the inflationary bias of the last fifty years were built on two primary assumptions. The first is that the labor force must be kept employed in order to avoid revolutionary unrest. The second assumption is that foreign exchange rates would be fixed in value. (See my book review: http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)

The model derived from these assumptions is “short-run” in nature. (Remember Keynes is quoted as saying “In the long run we are all dead.”) Policy making within this paradigm, therefore, focuses upon achieving short-run goals even if the long run consequences, as presented above, are detrimental to the people that are, hopefully being helped. Since the world is a series of short-runs, the problems resulting from previous “short-run solutions” will be offset at a later date. As we have seen, this does not happen.

In addition, since 1971 most of the world has been operating within a regime of floating foreign exchange rates. A country cannot isolate itself from other countries, in terms of the fiscal and monetary policies it follows, without repercussions. In the case of the United States, we have seen during this period of inflationary bias the value of the United States dollar has declined. The two periods in which this was not the case were those of the late 1970s-early 1980s, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System, and the 1990s, when Robert Rubin was an influential member of the Clinton Administration. Overall, however, the value of the United States dollar has declined during this period and is currently substantially lower, relative to other major currencies, than it was in the 1970s.

The policy focus of the United States government must change. To me, Paul Volcker had it right when he argued that “a nation’s exchange rate is the single most important price in its economy.” Consequently, he argued that a government cannot ignore large swings in its exchange rate. A country’s exchange rate reflects how international markets interpret the inflationary stance of the monetary and fiscal policy of a government. In the future, more emphasis must be placed upon this price in making policy decisions for the United States no longer dominates the world the way it did in the past.

Second, the policy focus of the United States government must move away from employment in legacy industries. A recent research paper by Dane Stangler and Robert Litan, “Where Will the Jobs Come From?”, published by the Kauffman Foundation, emphasizes that “nearly all” of the jobs created in the United States from 1980-2005 were created in firms less than five years old. By focusing on legacy industries in determining its economic policy, the federal government is just fostering an environment in which under-employment is going to continue to grow. This is not healthy for the future of the American economy, especially as emerging nations around the world are focusing on the future and not the past.

Future Long Term Treasury Rates

The ten year Treasury yield hit 4.00% yesterday, a level not hit since June 6, 2009. Then one has to go back to October 31, 2008 for the next time this yield hit the 4.00% level. The big question is, of course, where is the rate going to go from here?

Many experts claim that the outlook for longer term interest rates depends upon what is going to happen to inflationary expectations in the financial markets. With the Consumer Price Index for All Items hovering around the 2.0%-2.5% range, year-over-year, and the CPI less Food and Energy at the 1.0%-1.5% range, year-over-year, actual inflation is extremely low given the experience of the past 50 years or so.


So, what is the market anticipating in terms of inflationary expectations for the next ten years?


If one uses inflation-indexed government bonds as an estimate for the real rate of interest, then for a ten-year Treasury security the market seems to be estimating that the real rate of interest is now around 1.50%. If so, then with the nominal 10-year Treasury security around 4.00%, one could say that the market expects inflation, over the next ten year period to run about 2.5% or approximately at the upper end of the current range for the CPI for all items.


However, one could argue that the Treasury market has been the beneficiary over the past 15 months or so of two unusual forces, both connected with the financial collapse that began in the fall of 2008 and continue to this day. The first of these forces is the huge amount of funds that have flown to the United States and to Treasury securities connected with the “flight to quality” from the rest-of-the world. This “flight-to-quality” began in late 2008 and continued throughout most of 2009 with lapses here and there.


The second factor is the quantitative easing on the part of the Federal Reserve. This has helped to sustain very low market interest rates, long-term as well as short-term. The quantitative easing has also been accompanied by the Fed’s huge purchase program of mortgage-backed securities and Federal Agency securities that have provided a substantial amount of liquidity to the financial markets.


Both forces have resulted in Treasury yields that are substantially below what I would consider to be normal on a historical basis. And, these forces have impacted the inflation-indexed securities as well as the nominal-yield securities. Expected real rates of interest just do not drop to the level that the inflation-indexed securities have fallen to.


Historically, for the last fifty years, the estimate I have used for the real rate of interest tends to be around 3.0%. I won’t argue with 2.8% or with 3.2% because that is not the crucial issue. Before the 1960s, the real rate of interest seemed to be about 2.5% due to the slow growth period of the 1950s and this helps to account for nominal interest rates being so low throughout most of that period of time. Beginning in the sixties, however, the higher, 3.0% rate, seems to provide a relatively better estimate for the “expected” real rate of interest.


If one assumes that the “expected” real rate of interest for the next ten years is 3.0%, then one could argue that the current “realized” real rate of interest from the inflation-indexed securities resulting from the international “flight-to-quality” and the quantitative easing of the Federal Reserve is 150 basis points below what it otherwise would be.


Carrying this argument further, one could argue that the nominal 10-year Treasury security should be around 4.50% once the influence of the foreign “risk-averse” money and the Federal Reserve easing is accounted for. This would imply that the inflationary expectations built into the Treasury yield by the financial markets was about 1.5%, a figure that is at the high end of the current rate of inflation indicated by the CPI less food and energy costs.


But, you could go further than this. The Fed and Ben Bernanke have stated that the “informal” inflation target of the Federal Reserve is about 2.0%. If it is assumed that the Fed is able to contain inflation at this 2.0% level for the next decade, then one would assume that the 10-year Treasury yield should be around 5.0% to reflect an expectation of inflation of about 2.0%.
If the market believes that in the long run, the costs of food and energy should be accounted for in inflation, then, assuming that the upper bound of the current rate of CPI inflation for All Items, 2.5% is achieved over the next 10-years, then inflationary expectations should be at this level and the nominal 10-year Treasury yield should be around 5.5%


Of course, there is another body of thought that looks at the $1.1 trillion of excess reserves in the United States banking system and contends that there is no way the Fed will be able to remove these excess reserves from the banking system before bank loans expand excessively, money stock growth becomes extremely rapid, and inflation becomes a major problem again. To these investors, the assumption of inflationary expectations of 2.5% is ridiculous. Consequently, even a 5.5% 10-year bond rate seems excessively low.


One can argue that, as in the decade of the 2000s, many foreign countries have helped to finance the United States deficit and, as a consequence, and this has also kept United States interest rates lower than perhaps they would have been otherwise. Some analysts believe that this will continue. One can argue from many different sides of this argument for a specific level of interest rates relative to expected real rates plus inflationary expectations. I don’t really find this “supply of funds” argument convincing.


I believe that long term interest rates are headed up. How far they will go depends upon a lot of things, some of which I have tried to present in this post. If the economy continues to strengthen, I feel that the 10-year yield on Treasury securities should, over the next two years, be closer to the 6.00% level than the 4.5% level. There, I am on the record.

Inflation is in the News

There were quite a few articles in the newspapers this morning concerning inflation and how governments should set their policy targets with respect to inflation. This discussion was set off by a paper written by Oliver Blanchard, the top economist at the International Monetary Fund, and examined in this post on February 12, “Doesn’t Anyone Understand Inflation,” http://seekingalpha.com/article/188351-doesn-t-anyone-understand-inflation. The proposal of Mr. Blanchard’s that caught everyone’s eye was the proposal that central banks set their target rate of inflation at 4% rather than 2%.

This morning we see an opinion piece by Wolfgang Münchau in the Financial Times, http://www.ft.com/cms/s/0/9776aeb0-1ef2-11df-9584-00144feab49a.html; an article by Sewell Chan in The New York Times, http://www.nytimes.com/2010/02/22/business/22imf.html?ref=business; and another article by Jon Hilsenrath in the Wall Street Journal, http://online.wsj.com/article/SB20001424052748704511304575075902205876696.html#mod=todays_us_page_one. All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.

The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”

In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.

The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!

It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.

The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.

Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.

The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”

The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.

The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.

Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.

Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.

The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.

I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.

The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.

This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.

Inflation is Just Not Understood!

Funny time to be talking about inflation, but the top economist at the International Monetary Fund brought it up.

Oliver Blanchard, now serving at the IMF while on leave from MIT, has co-authored a new paper and has publically presented the results which have been reported in the Wall Street Journal: http://online.wsj.com/article/SB20001424052748704337004575059542325748142.html#mod=todays_us_page_one. Mr. Blanchard is now saying that central banks that were shooting for a 2% rate of inflation in their deliberations concerning monetary policy should shoot for something more in the neighborhood of 4% “in normal times.”

Economists of Mr. Blanchard’s philosophical bent just don’t seem to understand!

Inflation IS NOT the solution!!!

But, Inflation could very well be the problem!!!

As I keep saying, the post-World War II policy favoring an inflationary economic policy gained power on January 20, 1961. The basic format for such a program was followed, almost religiously, by Republicans as well as Democrats, into the 2000s. As a consequence, a United States dollar that could purchase one dollar worth of goods on January 20, 1961 could only purchase about seventeen cents world of goods in the summer of 2008.

Furthermore, inflation could not keep unemployment, or even more important, underemployment, down, as was originally believed and it could not keep industry working near capacity throughout the last 47 years or so. In fact, if anything, inflation forced manufacturing to focus on rising prices rather than productivity and this contributed to rising underemployment and declining capacity utilization. For more on this see my post, “The US Economy: Not Back to Business as Usual,” of January 8, 2010: http://seekingalpha.com/article/181621-the-u-s-economy-not-back-to-business-as-usual.

Inflation did create a “boom-time” for finance. Finance loves inflation because inflation that runs ahead of inflationary expectations reduces the burden of any debt outstanding. And what did we see between 1961 and 2008? We saw the greatest blooming of financial innovation in the history of the world and a rapid expansion of the finance industry relative to the rest of the economy that was even condemned by the people most responsible for the creation of the inflationary environment.

I have labeled this type of environment one of credit inflation (as opposed to debt deflation). It is referred to as credit inflation because it can incorporate price inflation, as in the case of the consumer price index) and asset inflation, as in the case of housing prices, dot.com boom, stock market boom, and so forth. Credit inflation relates to any time credit in the economy or in subsectors of the economy increases at a faster rate than the normal growth rate of that particular economy or that part of the economy.

And, this was a perfect time for financial innovation. I have just reviewed the new book titled “The Quants” by Scott Patterson, and he mentions many times in the book that the period from the 1960s into the 2000s, the period of the Quant-boom, as a period of “money ease”. In essence, monetary ease “lubricated” the Quant revolution helping to underwrite the massive growth in the financial industry and the development of the “shadow banking system.”

Of course, as Patterson describes, there were some consequences to pay for this expansion. But, I will let you read his book, or, at least, my review of his book, to gather his “take” on the subsequent financial collapse.

This gets me to the main point of this post. Blanchard, and other economists who think along similar lines, work with macroeconomic models that do not really include debt or the changing burden of debt in their models. Thus, the inflation in their models cannot provide an incentive for economic units to increase their use of debt and the subsequent buildup of debt can have no negative implications for the future performance of the economy. Inflation that causes an increased use of leverage and additional risk-taking cannot be explained in their models.

Thus, inflation remains the best solution to this brand of economist for the achievement of economic growth and lower rates of employment. The earlier debates about the Phillips curve seem to be irrelevant to them, let alone earlier discussions about debt deflation.

We are currently in a very precarious situation. Even with unemployment remaining so high and the economy staying so sluggish, more and more people are expressing concern about credit bubbles in the economy. China, who has recovered from the world economic collapse as fast as anyone, is showing tremendous concern about the possibility that bubbles may be forming in its economy and has taken measures with respect to its banking system to prevent such bubbles from occurring.

Still, our banking system contains $1.1 trillion in excess reserves and the Federal Reserve is faced with the problem of “undoing” this injection of reserves into the financial system. See my “Tightening at the Fed”: http://seekingalpha.com/article/187292-tightening-at-the-fed-get-ready-for-the-undoing.

Some economists still believe that re-flation is the only real solution to the current situation of a stagnant economy and massive federal deficits.

To me, Oliver Blanchard and these other economists that think like him just don’t get it! Yet they stick with the models that they have used over and over again and claim, if anything, that the reason why their solutions to the problem have not worked is because they either have not been tried or that they have not been implemented in a large enough size.

To my mind, their models and the solutions they have presented, have been tried and they have been found wanting. To me, to come up with a call for accepting higher rates of inflation in the future is, at a minimum, absurd. In fact, it scares me!

It's the Mood of the Workers, Stupid!

Robert Shiller of “Irrational Exuberance” has given us the answer to our problems in the Sunday New York Times. See “Stuck in Neutral? Reset the Mood!” http://www.nytimes.com/2010/01/31/business/economy/31view.html?scp=1&sq=robert%20shiller&st=cse. Shiller argues that, “In reality, business recessions are caused by a curious mix of rational and irrational behavior. Negative feedback cycles, in which pessimism inhibits economic activity, are hard to stop and can stretch the financial system past its breaking point.”

“Solutions for the economy must address not only the structural instability of our financial institutions, but also these problems in the hearts and minds of workers and investors—problems that may otherwise persist for many years.”

The solution: people must believe in the cause! “Reset the Mood!” “In most civilian fields, job satisfaction may not be a life-or-death matter, but a relatively uninterested, insecure work force is unlikely to bring about a vigorous recovery.”

But, the problem goes beyond the current malaise. Shiller advises us to look at the whole post-World War II period. He cites data from the Bureau of Labor Statistics and states that the annual growth of business output per labor hour averaged 3.2% from 1948 to 1973. From 1973 to 2008 the growth rate was 1.9%. He quotes Samuel Bowles of the Santa Fe Institute who has argued that the causes of this slowdown “are to be found as much in the loss of ‘hearts and minds’ of workers and investors as in the technology.”

A cause of this “loss of ‘hearts and minds’ of workers and investors” is not presented. Let me provide a possible cause: inflation!

Since January 1961 through 2009, the purchasing power of $1.00 has declined by about 85%, depending upon the price index used. That is, a $1.00 that could purchase $1.00 when John Kennedy became president could only purchase around $0.15 in 2009.

The “guns and butter” expenditure pattern of the federal government in the 1960s resulted in the wage and price freeze that came about in August 1971 along with the separation of the United States dollar from gold. The excessive inflation of the latter part of the 1970s resulted in the Federal Reserve tightening of monetary policy which finally broke the back of inflation in the early 1980s. Yet, even though the United States went through a period of moderate price inflation during the next twenty years or so (the Great Moderation) credit inflation continued. (For a review of what I mean by credit inflation see http://seekingalpha.com/article/184475-financial-regulation-in-the-information-age-part-c.)

This period of inflation had two major impacts on the United States economy. First, American manufacturers worried less about productivity than they did about getting products to market. Inflation does this to producers. Why? Because the pressure is on manufacturers to quickly get in new equipment so that they can meet the rising demand for goods and this means that executives focus less on the longer-lived, more productive plant and equipment and give their attention to more short-lived investments. As a consequence, productivity suffers!

The impact of this change in the composition of the capital stock of the United States is reflected in two other measures. First, capital utilization in manufacturing industry has continued to decline from the 1960s to the present time. (See chart: http://research.stlouisfed.org/fred2/series/TCU?cid=3.) For example, capacity utilization was above 90% in the middle of the 1960s. Through all the cycles in capacity utilization over the next 45 years, the peak rate constantly declined. In February 1973 the rate was slightly below 89%. The next peak was in December 1978 and was below 87%; then about 85% in January 1989; and again in January 1995 and in November 1997. The next peak came in August 2006 at about 81%. The most recent trough in capacity utilization came in June 2009 and has rebounded to 72% in December 2009. Expectations: it will not reach 81% again.

In addition, labor force participation has changed dramatically during this time period. Labor force participation increased substantially from the latter part of the 1960s until the latter part of the 1980s, primarily due to more women taking part in the measured labor force. Since the late 1980s the growth of total labor force participation began to slow down and in the 200s total labor force participation began to decline as more and more people became discouraged in looking for a job or only could find temporary employment. In 2009 the number of under-employed individuals of working age amounted to between 17%-18% of the labor force. Thus, we have unused capacity in the labor force as well.

The second major impact this period of inflation had on the United States economy was on the use and creation of debt. Inflation is good for debt creation! But, the foundation for the increase in debt during this time was the Federal Government, as the gross federal debt increased at an annual rate of 7.85% per year for the period of time from fiscal 1961 through fiscal 2009. The federal debt held by the public rose by 7.31% over the same time period.

Private debt, of course, increased very, very rapidly during this time period as did the financial innovation that spread debt further and further through the economy. Inflation is good for debt and it is also good for employment in the area of finance and financial services. As is well known there was a tremendous shift in the work force during this time from non-financial firms to financial firms. Furthermore, labor productivity does not increase as much annually in the finance industry as it does in non-finance.

Why should the labor force put its “hearts and minds” behind the future of the United States economic machine?

One sees no end to the environment of “credit inflation” created by the federal government. Estimates of federal government budget deficits still range in the $15-$18 trillion range for the next ten years which would more than double the gross federal debt that now exists. Then there are questions relating to the Federal Reserve’s inflation of the monetary base and the possibility that the central bank can pull off a magical “exit” strategy where the Fed removes roughly $1.1 trillion “excess” reserves from the banking system without causing any disruptions. The eminent scholar of the Federal Reserve System, Allan Meltzer, seems to have serious doubts about the Fed being able to pull this off. (See http://online.wsj.com/article/SB20001424052748704375604575023632319560448.html#mod=todays_us_opinion.) The failure to succeed here, along with the rise in the federal debt, would just further underwrite credit inflation in the whole economy.

The international investment community continues to have concerns over the ability of the United States to do anything different from what it has done over the last 50 years or so. There is nothing to indicate anything more than “business as usual” in Washington, D. C. If this is true, then we will see continuing credit inflation, sluggish performance in labor productivity, continued declines in labor force participation, and further softness in capacity utilization. And, if the environment of credit inflation continues, finance and financial innovation will continue to thrive.

We don’t need a change in the “hearts and minds” of the labor force. The change in “hearts and minds” that is needed is in the politicians in the federal government.