28 Oct 2010
Over the last four months official announcements by the US Federal Reserve and its Chairman, Ben Bernanke, have tilted explicitly in favour of creating a higher level of inflation in the United States. According to Iveagh's Cambiz Alikhani, this change in attitude represents a momentous change and a paradigm shift in the policy objectives of the world’s most important central bank.
After the “shock and awe” response to the great financial crisis of 2008 and the economic bounce that ensued in 2009, the jury was out as to what the “next step” in official policy might be. Earlier this year, as the US economy was continuing to accelerate during the first quarter, no one really knew whether policy action would now be adjusted to withdraw the excessive stimulus injected into the monetary system and whether the government would start to put its unsustainable fiscal deficit in order.
The challenge that remained, despite the unprecedented fiscal and monetary intervention of 2009, was that a de-leveraging process had been unleashed in response to the excess leverage that the economic system had taken on during the previous two decades and that this process was still under way, possibly with years to run.
Last week, when writing about the UK, Alikhani referred to a report published last January by the McKinsey Global Institute that concluded by stating that historically, there have been four ways of dealing with the problem of excess debt: belt tightening, high inflation, default and growing one’s way out.
The US is now extremely close to choosing the path of high inflation and the ground for this seems to have been prepared by the Federal Reserve over the last four months. The timing for this change of attitude was not driven by negative inflation data, as some may have reasonably expected, but by a soft patch in economic activity and more importantly, in my opinion, a 12% US stock market sell off during the second quarter on 2010 that was threatening to accelerate to the downside in the absence of Fed intervention.
What started as a small measure of additional quantitative easing in August when the Fed decided to reinvest coupons and maturities in its mortgage book into US Treasuries turned into explicit statements about the Fed’s dual mandate of full employment and stable inflation. We were told by Bernanke and various other Fed officials that further quantitative easing is warranted on the grounds that inflation is below the Fed’s target and that unemployment is too high. This debate rapidly shifted into stating that policy action was necessary irrespective of the near term path for growth and turned a dramatic corner over this month as the idea of “price targeting” inflation was muted, a very aggressive stance indeed. Price targeting of inflation implies aiming for “above target” inflation to make up for lost ground when inflation falls short of objective. This idea was muted by Kenneth Rogoff, former chief economist at the IMF in February 2009 when he called for excess inflation “right now” to counter the threat of debt deflation. “It would be far better to have 5% to 6% inflation for a couple of years than to have 2% to 3% deflation” he said.
One can understand such talk during February 2009, at the lowest and darkest point of the post Lehman crisis but it is somewhat less comprehensible now. After all, Fed’s core inflation measure is currently running at +1.4% year on year, the US stock market has almost doubled from its March 2009 low, banks are in the process of restoring their balance sheets and growth is running close to trend . We are not even in deflation and yet we are being told that extreme policy measures to combat deflation are necessary. How can that be?
The answer lies in the debt deleveraging process that is occurring and the four options available to deal with it. The facts are being made to fit the chosen course of policy action rather than the other way round as in order to justify a policy of inflating the way out of debt.
The US is NOT currently experiencing deflation, rather it is going through disinflation as a result of the bursting of the debt bubble. In fact we are much closer to the level of inflation that is consistent with the Fed’s mandate than deflation, and at a level that prevailed for periods during the 60’s and 90’s.
It has been said of late that consumer psychology in the US today is “why spend today when I can buy goods cheaper tomorrow”? This is completely wrong. The consumer is disposed in its current manner because it is in a deleveraging process and such a process requires paying down one’s debt as opposed to accumulating more. It has nothing to do with negative price expectations. Data from the McKinsey report show that total debt as a percentage of GDP in the US stood at 290% in 2008, that US household debt was equivalent to 96% of GDP and that the US household debt to income ratio stood at 128%. That is why the US consumer is deleveraging, not because of expectations of price falls. In fact data released on October 1st by the University Of Michigan Consumer Confidence Survey suggested that inflation expectations one year ahead are running at 2.2% and five years ahead at 2.7%!
A similar process is going on with the banks. They too, need to reduce leverage and to restore their balance sheets. The McKinsey report states that total financial system leverage stood at 35 X in 2007 and tangible assets to equity in the system rose 32% in the period from 2002 to 2007. It shows that leverage at the GSEs (Government Sponsored Enterprises such a Fannie Mae) stood at 66 X in 2006 and that leverage in the commercial real estate sector measured as debt divided by book equity rose from 1.5 in 1998 to 3.1 in 2008. That is why the financial system is deleveraging and not lending aggressively, not because it expects prices to fall.
For reasons best known to a number of Fed policy makers and by no means all, the US is refusing to go down the path of belt tightening and showing some patience in the face of a severe deleveraging process and disinflation. Zero rates and ultra loose monetary policy would in all likelihood get the job done, albeit over a longer time frame but the advantage would be that the ensuing recovery would be robust and sustainable.
Furthermore, the status of being the world’s reserve currency should not be abused as it threatens to be now. In the short term it means that inflation gets exported to the rest of the world, easing the burden on the US but in the long term it can be very damaging.
Such sentiments echo those of Kansas City Fed Governor Thomas Hoenig, a voting member of the FOMC, who recently said that “quantitative easing is a dangerous gamble that risks higher costs in the economy and another financial crisis. Central banks need to think of the long term“.
Or one may consider the words of German Economy Minister, Rainer Bruederle last week, when he said that adding liquidity “is the wrong way to prevent or solve problems”.
Perhaps Bernanke’s gamble is that the threat of action will get the job done without policy action becoming necessary.
We await the long anticipated Fed policy announcement next week. If it follows the inflationary path that has been heavily flagged of late its market consequence will be positive for nominal prices of equities, real estate and commodities during the period of policy action. Since printing money will involve buying US Treasuries, a false market in those securities will be extended and broadened, thereby transferring volatility into equity markets.
After the “shock and awe” response to the great financial crisis of 2008 and the economic bounce that ensued in 2009, the jury was out as to what the “next step” in official policy might be. Earlier this year, as the US economy was continuing to accelerate during the first quarter, no one really knew whether policy action would now be adjusted to withdraw the excessive stimulus injected into the monetary system and whether the government would start to put its unsustainable fiscal deficit in order.
The challenge that remained, despite the unprecedented fiscal and monetary intervention of 2009, was that a de-leveraging process had been unleashed in response to the excess leverage that the economic system had taken on during the previous two decades and that this process was still under way, possibly with years to run.
Last week, when writing about the UK, Alikhani referred to a report published last January by the McKinsey Global Institute that concluded by stating that historically, there have been four ways of dealing with the problem of excess debt: belt tightening, high inflation, default and growing one’s way out.
The US is now extremely close to choosing the path of high inflation and the ground for this seems to have been prepared by the Federal Reserve over the last four months. The timing for this change of attitude was not driven by negative inflation data, as some may have reasonably expected, but by a soft patch in economic activity and more importantly, in my opinion, a 12% US stock market sell off during the second quarter on 2010 that was threatening to accelerate to the downside in the absence of Fed intervention.
What started as a small measure of additional quantitative easing in August when the Fed decided to reinvest coupons and maturities in its mortgage book into US Treasuries turned into explicit statements about the Fed’s dual mandate of full employment and stable inflation. We were told by Bernanke and various other Fed officials that further quantitative easing is warranted on the grounds that inflation is below the Fed’s target and that unemployment is too high. This debate rapidly shifted into stating that policy action was necessary irrespective of the near term path for growth and turned a dramatic corner over this month as the idea of “price targeting” inflation was muted, a very aggressive stance indeed. Price targeting of inflation implies aiming for “above target” inflation to make up for lost ground when inflation falls short of objective. This idea was muted by Kenneth Rogoff, former chief economist at the IMF in February 2009 when he called for excess inflation “right now” to counter the threat of debt deflation. “It would be far better to have 5% to 6% inflation for a couple of years than to have 2% to 3% deflation” he said.
One can understand such talk during February 2009, at the lowest and darkest point of the post Lehman crisis but it is somewhat less comprehensible now. After all, Fed’s core inflation measure is currently running at +1.4% year on year, the US stock market has almost doubled from its March 2009 low, banks are in the process of restoring their balance sheets and growth is running close to trend . We are not even in deflation and yet we are being told that extreme policy measures to combat deflation are necessary. How can that be?
The answer lies in the debt deleveraging process that is occurring and the four options available to deal with it. The facts are being made to fit the chosen course of policy action rather than the other way round as in order to justify a policy of inflating the way out of debt.
The US is NOT currently experiencing deflation, rather it is going through disinflation as a result of the bursting of the debt bubble. In fact we are much closer to the level of inflation that is consistent with the Fed’s mandate than deflation, and at a level that prevailed for periods during the 60’s and 90’s.
It has been said of late that consumer psychology in the US today is “why spend today when I can buy goods cheaper tomorrow”? This is completely wrong. The consumer is disposed in its current manner because it is in a deleveraging process and such a process requires paying down one’s debt as opposed to accumulating more. It has nothing to do with negative price expectations. Data from the McKinsey report show that total debt as a percentage of GDP in the US stood at 290% in 2008, that US household debt was equivalent to 96% of GDP and that the US household debt to income ratio stood at 128%. That is why the US consumer is deleveraging, not because of expectations of price falls. In fact data released on October 1st by the University Of Michigan Consumer Confidence Survey suggested that inflation expectations one year ahead are running at 2.2% and five years ahead at 2.7%!
A similar process is going on with the banks. They too, need to reduce leverage and to restore their balance sheets. The McKinsey report states that total financial system leverage stood at 35 X in 2007 and tangible assets to equity in the system rose 32% in the period from 2002 to 2007. It shows that leverage at the GSEs (Government Sponsored Enterprises such a Fannie Mae) stood at 66 X in 2006 and that leverage in the commercial real estate sector measured as debt divided by book equity rose from 1.5 in 1998 to 3.1 in 2008. That is why the financial system is deleveraging and not lending aggressively, not because it expects prices to fall.
For reasons best known to a number of Fed policy makers and by no means all, the US is refusing to go down the path of belt tightening and showing some patience in the face of a severe deleveraging process and disinflation. Zero rates and ultra loose monetary policy would in all likelihood get the job done, albeit over a longer time frame but the advantage would be that the ensuing recovery would be robust and sustainable.
Furthermore, the status of being the world’s reserve currency should not be abused as it threatens to be now. In the short term it means that inflation gets exported to the rest of the world, easing the burden on the US but in the long term it can be very damaging.
Such sentiments echo those of Kansas City Fed Governor Thomas Hoenig, a voting member of the FOMC, who recently said that “quantitative easing is a dangerous gamble that risks higher costs in the economy and another financial crisis. Central banks need to think of the long term“.
Or one may consider the words of German Economy Minister, Rainer Bruederle last week, when he said that adding liquidity “is the wrong way to prevent or solve problems”.
Perhaps Bernanke’s gamble is that the threat of action will get the job done without policy action becoming necessary.
We await the long anticipated Fed policy announcement next week. If it follows the inflationary path that has been heavily flagged of late its market consequence will be positive for nominal prices of equities, real estate and commodities during the period of policy action. Since printing money will involve buying US Treasuries, a false market in those securities will be extended and broadened, thereby transferring volatility into equity markets.
