Inflation is our friend, says Fed

EXACTLY what game is Alan Greenspan playing? Or is he too frightened to tell us? Last week the Federal Reserve that he chairs catalysed an anxious debate across America and the markets that the world’s biggest economy could be heading for deflation. This is quite the nastiest word in central bank parlance and immediately conjures up the spectre that Japan’s disease could be spreading world wide.

The Fed’s Open Markets Committee left interest rates unchanged at 1.25%. But this was instantly overshadowed by what some have hailed as the most important statement, aimed at diverting deflation risks, since Paul Volcker set out in 1979 to kill inflation. Put starkly, the official policy of the Fed is now the encouragement of inflation.

As ever, the finely nuanced statement did not put matters quite so bluntly. Indeed, the key conclusions of the Fed are puzzlingly contradictory. First, it said on economic growth that "over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal". Then, on inflation, it said that "the probability of an unwelcome (my emphasis) substantial fall in inflation, though minor, exceeds that of a pick-up in inflation from its already low level".

Third, on the overall balance of its deliberations on the economy, it summarised its conclusions thus: "The balance of risks to achieving its goals is weighted towards weakness over the foreseeable future."

After 30 years of central bank orthodoxy in which inflation was the first and greatest enemy to see a statement describing a substantial fall in it as "unwelcome" is, to put it no stronger, unusual. But it appears to be a measure of the Fed’s concern that the prospect of falling prices could defer business and consumer spending and bring about the very deflation that some so fear. If that is the case, it is surprising that its conclusion on prospects for economic growth was neutral. For surely growth would be faltering, too.

Now, it may be this was indeed the message, albeit in contorted form, that the Fed was trying to convey. Perhaps it felt it could not say so directly, for fear of upsetting a fragile recovery on Wall Street. But that is the conclusion some will draw. And the policy implication appears to be that the Fed is now moving from a position of all-out inflation beating to one of inflation targeting, similar to that of the Bank of England. George Magnus, economics guru at EBS Warburg, describes it this weekend as "a de facto stealth inflation target and is putting us on notice that there’ll be no pre-emptive tightening. In fact, no tightening for a long time - and if demand falls again, more easing".

The fact that the Fed’s remarks have created such resonance suggests that its warnings are shared by many and that it therefore did not need to be so mealy-mouthed about coming out with them. There is a widespread concern that while the American economy may not be heading for any sharp recessionary crunch, it is not really heading towards a recovery, either.

‘Deficits are billowing, the dollar is falling and there are worries about growth - but no sense of crisis’

The economist Robert Samuelson, writing in the Washington Post last week, says the US economy is in the grip of what he has called "the new stagnation". It is not in economic free-fall, but it is not in recovery, either. There is rising insecurity about jobs (the jobless rate rose from 5.8% to 6% in April) and a persisting squeeze on both government social spending and corporate profits.

In addressing all of this the sceptics say the Fed is now a busted flush. It has already cut interest rates 12 times since 2001. What makes us think that a 13th cut will succeed in kick-starting a recovery where the preceding dozen have so signally failed?

Since late 2000, annual US economic growth has averaged about 1.5%, compared with an average of 4% in 1996-2000 period. About 2.1m jobs are reckoned to have vanished. The stock market has lost 40% since its peak. Yet despite all of this, the economy is still sustaining 130 million non-farm jobs and house prices are still rising - up by 7.1% last year.

According to Samuelson, Japan pioneered the new stagnation and the parallels are disturbing. In the 1990s, its economy foundered. But unemployment rose only gradually and most people continued to do well. Everyone thought that once the aftershocks from the bursting of its stock market bubble had subsided, its economy would recover. It never did. Since 1992, Japan’s growth has averaged 1% a year - in the 1980s, it grew by an average 3.8% annually.

The US is not like Japan. But it could, Samuelson warns, fall into the same trap: there is huge surplus capacity. Neither Europe nor Japan look remotely capable of picking up the growth baton.

These demons are not only devouring economic growth but also the dynamics of efforts to revive it, such as interest and tax cuts. Japan-style deflation no longer looks as preposterous as once it did.

However, the more encouraging data should not be overlooked. On Friday the Dow Jones Index surged 1.3% on upbeat statements from computer chipmakers Nvidia and Intel. This comes on top of a 16% surge in the broader S&P 500 Index since mid March. Better-than-expected corporate earnings in the first quarter suggest massive workforce cutbacks and restructuring may be forming the base of a sustained recovery. Two thirds of the companies in the S&P 500 beat Wall Street’s estimates. And this appears to be igniting a more confident mood among investors. In the past two weeks about $10bn has flowed back into US mutual equity funds.

There are also good reasons to expect an improvement in consumer confidence and company earnings: oil prices are falling; George Bush is determined to pursue his tax cut proposals through Congress, and the 12% fall in the dollar should help overseas demand for US products.

But sceptics are not convinced. Samuelson fears that it is the absence of any sense of crisis that will prolong the very stagnation that is building up huge disruptive pressures in bond and currency markets. Certainly, if the dollar continues to fall, and there is no recovery in Europe strong enough to spark a big upturn in US exports, there are real dangers that America’s current account deficit will get of hand. In previous years, a combination of a spiralling trade deficit and a spiralling budget deficit would have rung the policy alarm bells. Today, both deficits are billowing, the dollar continues to fall and there are worries about growth - but no sense of crisis at all.

Some might see, in the Fed’s complex and oddly inconsistent signalling, an attempt to spark a non-traumatic crisis, to let the air slowly out of the balloon of Washington complacency, just as in the late 1990s it wrestled with the problem of how to let the air out of a vastly over inflated stock market. It may be, of course, that the Fed is simply being cautious, as all central banks have a bias to be. But it has chosen a darkly convoluted way to go about it.

The classic definition of inflation is the inefficient use of money.

Given our fractional reserve system and the continuous printing of money as a marker of our peculiar form of economic success "inflation" could be made to stand relatively still as long as demand for products grew along with the supply of money.

It is the stall in demand for goods that initially causes what is now an (overprinted) oversupply of money to go into a deflationary mode.

I think we have one more phase of demand that will see pick up again for a few more years. Then there will be hell to pay.

For years I listened to the conventional wisdom and was opposed to inflation because the government and the newspapers said we should be opposed.

Then one day a friend with a comparable job to mine, but somewhat greater financial success in life said to me: "Why should we be against inflation? I personally have benefitted greatly from inflation?"

I reviewed my life's financial history and realized that I too had benefitted from inflation. The only problem was that I had not properly positioned myself to take full advantage of inflation.

I started living well below my means and made some investments which would benefit from inflation. As I approach retirement I realize that these few words were the best advice I had ever received.

The bottom line here is that once a government issues paper money, inflation is created becasue it is always easier for the government to print more money than to take it in taxes. Betting that politicians will be fiscally irrresponsible is always a good bet.

As I have pointed out before, Greenspan had one knob to turn: interest rates. Since you cannot set the interest rate to zero or negative, each turn of the knob brings you closer to 'zero control authority'; i.e., that trick won't work anymore.

Since turning the interest rate knob down kept Clinton in office--among other things--there is precious little control authority any longer.

Ergo, the economy will do as it will and Greenspan is powerless to do anything about it. Indeed, about the only thing he can do is turn the interest rate knob the other way, increasing rates and stimulating inflation. So to suddenly discover that 'deflation' is a danger is risible: all he can do is inflate, and make himself to be a knight in shining armour against the 'deflation' dragon that he himself created.

--Boris

Anyone who is paying attention to what is happening with the Fed in the past year and has not taken some kind of position in gold and/or foreign currencies is going to kick themselves in the next four years. By fall I'll be debt free, with the exception of my mortgage, and I'm already taking steps to hedge against that debt should things play out the way they have been going.

Maybe (political) conditions have changed enough so that it can't happen again, but the whole of the 19th century was a period of long, slow deflation. So I'm not sure inflation is inevitable.

Slow deflation is tolerable, like slow inflation, but a deflationary cycle is more disastrous than any form of inflation besides hyperinflation. Deflation, besides meaning that tomorrow's price will be smaller than today's (leading people to defer purchases, which means more deflation) also means that the value of debts increases. If that increase is more than small, it results in a lot of bankruptcies, and those bankruptcies reinforce the deflationary cycle. Our governments now know how to bring inflation under control. The methods may be painful, but they are well-known. The failure of Japan to stop deflation after 10 years shows that governments do not yet know how to bring a deflationary cycle under control.

We only have deflation in the goods sector of the US economy, services have plenty of inflation. And we all know why we have goods deflation: importing of manufactured goods made by ultra low cost labor overseas. In addition, productivity increases within the US allow companies to deliver goods at lower costs. In Japan, they have a totally different scenario, their deflation is mainly caused by lack of demand, they have done nothing to foster an internal economy of their own. Japanese people buying goods and services inside their country. They thought they could export their way to prosperity, it worked for a while, but China is killing them. For Japan to fix this, they need a cultural change. In the US, everyone loves to consume, its not a problem.

it is surprising that its conclusion on prospects for economic growth was neutral.

It was not neutral. The conclusion that it was neutral is a very common mistake that people make when assessing probabilities in their heads. What the Fed actually said was,

"over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal"

Many people will interpret this to mean that the "most likely" outcome is somewhere around the middle, i.e. that they are 'neutral' about the prospects for growth. But that's not what it means.

What it means is that the band of reasonably probable outcomes is wider than usual. It amounts to saying, "The growth rate might go up, and it might go down. In fact it might go up by a lot. And it might go down by a lot. We don't know which, because those all appear to be equally likely outcomes. That is not the same thing at all as saying, "The best guess is that it will be somewhere in the middle." The real best guess is that whatever it is, it will be a surprise.

This is not a happy time to be a banking regulator. A wildly unpredictable future is the fright scenario, because all the tools at your disposal take months before they will have an effect. My guess is that when they finally conclude that the economics can't tell them anything, they'll go with the politics: step on the gas.

what would happen if the Fed purchased long-bonds (government and otherwise) on the open market... pushing cash into the economy in this manner?

Probably not as much as leaving cash in the economy by passing tax cuts. The problem with doing it via monetary policy is that it's pushing on a string. You can put the cash in the banks, but you can't make people borrow it. Companies are not going to borrow to put up new PP&E until they see some evidence that sales are rising. Even a low interest rate is still a new expense item, and that scares people right now.

Maybe (political) conditions have changed enough so that it can't happen again, but the whole of the 19th century was a period of long, slow deflation. So I'm not sure inflation is inevitable.

At least in the US, and I suspect throughout the world currency was backed by gold. This limited the treasury printing presses. In the 1930's the gold backing was removed, and that makes inflation inevitable.

Inflation is not a new trend. The Roman aureus started out as nearly pure gold, centuries later it was less than 1% gold. This is the best they could do without paper money.

Rather than messing with the Fed Funds Rate, what would happen if the Fed purchased long-bonds (government and otherwise) on the open market, driving down long-term rates while leaving short-term rates intact and pushing cash into the economy in this manner?

I'm pretty sure that they are already doing that, at least on the government side, in what is euphamistically called the "Greenspan Put." They may or may not be doing this in the private dent markets as well. There are even rumors that the Fed might be buying S&P and/or futures on Dow componants via offshore accounts, which might explain the sudden buying action that the market has seen following any decline in stock market indecies, even on news that the market typically sees as negative. Treasury (under Rubin) did this in the currency markets in the 90's to sandbag traders that were shorting the dollar. They (Treasury) are legally allowed to intervine in the currency market via the Exchange Stabilization Fund. Hard telling what is going on behind the scenes.

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