Ruminations, December 22, 2013
-- Inflation is an outlier. That doesn’t mean it won’t happen
An “outlier” is a mathematical term indicating something that deviates from the norm. For example, if you had a series of mathematical points that clustered in a specific area and one point that was nowhere near that area, the single point would be called an outlier.
But the term has morphed into non-mathematical expressions. For example, when Copernicus first published his theory in 1543 that the sun was the center of the universe and not the earth, his theory was an outlier. An “outlier” then is not necessarily wrong but just out of the mainstream.
Among economists at the Federal Reserve (the Fed) today, “inflation” in the U.S. is an outlier. That is, inflation has been very low (too low, says the Federal Reserve Chairman Ben Bernanke) and not an immediate danger to the economy. Therefore, if the Fed policies continue to be inflationary, they see no danger of inflation.
Is inflation a potential problem? Inflation is slowing across the world. Fed’s target is 2 percent, but only hit 1.2% last year (the Fed’s preferred target – personal consumption expenditures – hit 0.7% last year). European Central Bank’s (ECB) target was also 2 percent but they hit just 0.9 percent last year. If the best and brightest bankers across the globe cannot raise inflation to the level at which they want it, what does that tell you? Maybe it says that the bankers are neither as knowledgeable nor capable as they think they are? And what does it say when they do the same thing (printing money) over and over and hoping for a different result?
The economist Copernicus (the very same Copernicus) developed the quantity theory of money which says that if the supply of money keeps increasing without a proportional increase in goods and services, we will, over the long run, have inflation. If Copernicus was right, why do the central bankers keep printing money? Because they believe that in the short run, an increased supply of money will increase employment and therefore goods and services; and any untoward increase in the money supply can then be reduced later. Theories contrary to the bankers’ theory are outliers.
One of the other (other than long-term and short-term) aspects of the quantity theory of money that economists cite to mitigate the inflationary results is the “stickiness” of money. By stickiness they mean that people tend to stick to what they have been doing. In this case, an increase in the supply of money will not cause people to spend it faster – immediately, anyway. During the economic downturn that began in 2008, people have been relatively risk averse and, figuratively, have put their money under the mattress.
Promoting inflation. So the Fed and their supporters believe that the best approach is to continue to print money and to tempt consumers with more and more money (Bernanke’s announcement last week was that the Fed will continue to print money but it will print it more slowly). But, as former Fed chief Paul Volcker has suggested, what if the Fed decides that since unemployment remains high (7 percent in the U.S. and over 12 percent in Europe), maybe the inflation target of 2 percent should be revised to 3 percent and if that doesn’t work, 4 percent and on ad nauseum – where does it stop? That could get us into real trouble.
It seems that the Fed is ignoring the lessons of the 1970s when unemployment was high and the Fed printed more money in an effort to stimulate employment; as a result unemployment rose(to almost 11 percent) at the same time inflation ratcheted up (to almost 15 percent) -- what became known as stagflation. It was only when the new Fed chief, Volcker, ignored unemployment and tamed inflation that we had the basis for growth and stability through the 1980s and 1990s.
But there is another aspect of inflation that is seldom mentioned. Inflation is a stealth tax on savers and it cheats bond holders. If you put $100 in the bank and government policy deliberately causes 2 percent inflation that means that at the end of one year the purchasing power of your $100 is now $98. It is a tax on savings that congress has not passed and the president has not signed but it is an effective tax, nonetheless. Furthermore, if, under the same circumstances, the government borrows $100, one year later they would only have to pay back the equivalent of $98 one year later (and regardless of what you read about China and Japan, most U.S. bond holders are Americans).
Inflation is, to a significant degree, psychological. If you, as an individual, expect prices to rise in then future then you will make your purchases now. What happens if mass psychology kicks in and people start spending to beat future price rises? Given all the money that has been printed and the inflationary stimulus programs that the central banks and governments have initiated, will these central bankers be able to reign in hyper inflation?
Dangers of deflation. But some economists see deflation as an imminent danger. Because, they posit, in spite of the massive printing of money without a significant increase in prices, eliminating the Fed inflationary program would result in deflation; prices would drop. As a result, consumers would postpone spending anticipating lower future prices. With reduced consumer spending, production would drop and more layoffs would occur. That would create a situation that would be indeed difficult, if not impossible, for central banks to remedy. So, the thinking goes, it’s better to err on the side of a little inflation than to risk a deflationary spiral.
It’s sound thinking. But is there really a risk of deflation? Forbes magazine last month said that “the biggest source of risk at present: deflation in the developed world. All of the past week’s data point to heightened deflationary risks. Paltry U.S. consumer price index (CPI) figures, German producer prices undershooting and another bout of weakness in commodity prices, particularly oil, suggest deflation is winning the battle over central bank stimulus.”
That sounds scary but is it really? The “paltry” CPI index has been relatively consistent over the five years (including 2013) at about 1.5 percent with the first 10 months of 2013 coming in at a little over 1.5 percent. It looks reasonably stable.
German producer price have dropped but some of that was caused by the drop in energy prices. And the higher prices commodities (such as oil and gold) that existed a short time ago, were in part caused by the low interest rates set by central banks (to get a better return, money got diverted from treasuries into commodities creating a minor economic bubble – and crude oil, although the price has dropped over the last five months is still higher than it was a year ago). And, over time, commodity bubbles burst – witness the recent drop in gold prices of 36 percent.
Many economists cite the case of Japan when looking at deflation. True enough. Japan has been in economic stagnation since 1998. In 1998, the Japanese consumer price index was at 104.2 and since that time it has declined to 99.7 – 4.2 percent over 15 years. Not to belittle Japan’s economic problems, but maybe there’s another cause. In his 2011 book, The Real Face of Deflation, Japanese economist Kosuke Motani, argues that deflation is not a problem that can be resolved by monetary policy because it is a structural problem. The roots of the problem are low cost competition from other Asian nations, the decrease in available workers and declining productivity. (But if you work in a central bank and your only tools are money supply and interest rates, you are likely to dismiss Motani’s thesis.)
But sometimes Bernanke seems to be saying let’s take actions counter to common sense. At his December 12 press conference, he said “… as a general rule, and I think this is the right baseline, the long-term unemployment rate is determined by a range of structural features of the economy and a range of economic policies and not by monetary policy.” If that’s what Bernanke believes then why is he printing money?
The worst of inflation and the worst of deflation. If continuing to print money runs us the risk of hyper inflation, we should at least have benefits of that policy and not the down-side. At the conclusion of the Fed’s Quantitative Easing (QE) program, it is expected that the Fed will have some $4.5 trillion in bonds on which to make good.
Well, at least we won’t have anything like deflation with which to deal. Or maybe we will. While long term rates will begin to rise as the Fed tapers back on its QE program, the Fed will keep short term interest rates low. But doesn’t keeping short term rates low contribute to the same mindset as deflation: Why invest or expand today when rates will be lower (or in this case, the same) as they will be tomorrow?
Economic bubbles. Former Fed Chairman Alan Greenspan said in testimony before Congress that economic bubbles are impossible to see until they burst. Well, that all depends on whether or not you’re looking for them or not. Certainly the high tech bubble that burst in 2000 was apparent to many economists as Greenspan was speaking.
As the housing bubble began to gain momentum in 2002, the Fed should have reacted. Instead, they ignored the bubble until it burst in 2007. (Full disclosure: Both Bernanke and Greenspan deny that there was a housing bubble.) And what has the Fed done since then? They have worked to re-inflate the housing bubble.
The stock market has increased 26 percent in the last year. Is it a bubble? Probably. Given the low rate of return on treasuries foisted on bond holders, investors have turned to the stock market (as well as commodities). (In support of this thesis, economist and former Treasury Secretary Larry Summers wrote last week that “it is only rational to recognize that low interest rates raise asset values and drive investors to take greater risks, making bubbles more likely.”) As the Fed begins “tapering” back on its QE purchases, bond interest rates will rise and some investors will dump stock in favor of bonds. The result will be a burst stock market bubble.
So where are we? Bernanke is in a good position; he is retiring and leaving the hard work, insofar as breaking out of QE and easing the economy back into a market defined equilibrium, to his successor, Janet Yellin. What will Yellin do? We don’t know for sure. She has been described as a pragmatist who shares Bernanke’s monetary philosophy – seemingly contradictory terms. If she follows Bernanke’s policies closely, she may lead the world economic community into what some economists refer to as secular stagnation: lower demand, lower investment, higher savings and, as been suggested, greater market intervention by the government. Or, as other economists have suggested, it could lead to currency wars as countries devalue their currencies to gain advantage over their neighbors.
If Yellin is more pragmatic, she may break out of QE more quickly and bring the United States and the world (the Fed Chief does have influence) back to a rational monetary policy and reduce or eliminate the target inflation rates. But even then, the Full Employment Act may force the Fed to with QE for too long – until inflation exceeds its target rate and it becomes impossible to control.
Quote without comment
Economist John Maynard Keynes, writing in his 1936 book, General Theory of Employment, Interest, and Money: “By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”