The Inflation Boat Is Leaving the Dock

On Wednesday night we learned that the Federal Reserve is going to put into practice its announced plan to buy U.S. government debt. Yesterday's Financial Times article by Krishna Guha gives the gory details.

Everyone knows that this action by the Fed increases money supply, and most are aware that it increases the probability that at some point in the future the amount of money created will be excessive with regard to the actual needs of the marketplace, which in turn will tend to lead us towards a state of price inflation, or bubble inflation. Another article by Javier Blas on the early signs of this in the commodities markets is a fun read on the subject.

As the Fed sees the problem, then, they must feed us with money supply while the banks are frozen in a state of rigor vivus, and then in the future, just at the right moment, they will take steps to prevent the normal outcome of price or bubble inflation by reversing the process.

This sounds logical. As an obscure economist named Edward C. Harwood wrote during our last episode of purposefully inflationary Federal Reserve intervention ("the ill-fated Operation Twist in the 1960s"), during a time when we were still trying to adhere to a modified form of the global gold standard:

Once inflationary purchasing media have been placed in circulation, there are two ways in which sound money-credit relationships may be restored: (1) by means of devaluation, that is, reducing the gold weight of the monetary unit so much that the increase in the number of (smaller) gold dollars equals or exceeds what had been the inflationary portion of total purchasing media; or (2) by means of deflation, that is by removing inflationary purchasing media from circulation." [See this article from the American Institute for Economic Research website [AIER.]

Let's take these in order. In the 1960s during the last years of the gold standard era, the word "devaluation" had by definition a specific political action attached to it. We could say it was an official public confession to a previously committed inflationary crime, the central bank's admission of guilt and acceptance of their incapacity to rectify the situation. To devalue a currency was ripe with ominous significance, and central banks were supposed to take pains to avoid the embarrassment by not inflating the currency in the first place.

Today, however, the devaluation of our currency takes place painlessly for most of us (except for importers), and effectively the Fed gets away with it on a regular basis. In fact, without a gold or any kind of standard, the inflationary purchases of debt instruments that the Fed has already made, plus those it intends now to make, are already devaluing the dollar as I write. We don't have to wait for an official recognition and adjustment of any standard; it just happens on a day-to-day basis.

Under these circumstances, an official announcement of devaluation, therefore, will have no corrective effect. Quite the contrary, inflation will take place simultaneously with the devaluation of the dollar--a double whammy, if you will.

But we don't want prices to skyrocket, so the inflation will still need correction. Let's turn to the other option, deflation. Paradoxically, the Fed is taking its present inflationary action to fight fear of deflation. They are afraid that a banking panic and a lack of credit could cause the system to collapse in what is called a "deflationary spiral." So it will be a while before they feel comfortable with using the deflationary tactic.

Nevertheless, the Fed scientists and governors do believe that it will be possible for them, at some appropriate moment in the future, to begin a controlled deflation of money supply that will not upset the apple cart.

Harwood does write this about the possibility of a controlled deflation:

That a period of gradually declining prices can be a period also of great economic growth has been amply demonstrated in the past. For example, between 1875 and 1895 while prices decreased substantially, the Nation's productive capacity and output of goods and services increased at a very rapid rate. The often heard assertion that an economy cannot grow unless prices are rising has no basis in fact....
With gradual deflation, a longer time would be required to eliminate all inflationary purchasing media and reach an equilibrium between the remaining (noninflationary) purchasing media and prices and wages, but the traumatic events that are a feature of rapid deflation would not occur. The Nation would 'outgrow' the inflationary condition as part of the savings of individuals, businesses, and perhaps of the Government were used to pay off inflationary bank loans and thereby cancel both the loans and the checking deposits that the loans had created. Although gradual deflation would be accompanied by decreasing prices, wages almost certainly would decline less or might even be sustained by greater productivity due to technological and other developments.

(For more on why deflation is not always bad thing, read this research by David Beckworth at Cato.)

So it would seem that a gradual well-timed deflation is what Bernanke and his cohorts are counting on. But... there are a few minefields here. One is that we are no longer on a gold standard. We have no point of reference as to where the dollar should end up. I won't go into the reasons why this makes Bernanke's task more difficult, but it does.

Second, how will we know when prices begin to inflate or when bubbles start to form? Alan Greenspan is famous for having remarked that it is impossible to detect when a bubble is appearing. It's true that we all knew the real estate mania was a bubble (or at least I did; didn't you?), but our financial wonks at the Fed either preferred not to recognize it or couldn't prove it to their own satisfaction, at least not to a point where it would have forced them to take action. (I'd add that they may have had incentives not to want to find reasons to take that action, but that would be unfair speculation, so I won't.)

And what if prices remain the same? Does this necessarily mean that we don't have an inflationary maladjustment in the money supply that maintains prices at an artificially stable but too high level?

Third, and here's the real rub, we have not practiced what Harwood calls "sound money-credit principles" since the Fed was created. These principles mandate a specific equilibrium in the commercial banking system between true reserves, deposits, savings, and short-term commercial paper on the one hand; and loans and investments that are speculative and / or based only on some form of collateral, on the other, where these more risky activities would be allowed only outside the strict commercial banking system. (For more on sound commercial banking, find a copy of Harwood's book "Cause and Control of the Business Cycle," 1974 edition, at your local library, or at from the AIER catalog. I will delve into the idea of sound money-credit banking in a future blog.)

Fourth, the Fed cannot reverse its current trajectory and start to take deflationary action until the time is right and the worst of the credit crisis is past. Will nothing unexpected disturb their plans? They are relying on deflationary scenario computer models where "all else is equal," meaning when outside factors remain stable. What if the market does something surprising that will make a controlled deflation either inadvisable or even impossible, at the very moment when it must happen?

For example, U.S. treasury bonds could become radically less popular among our foreign buyers as a result of the dollar devaluation the inflation will cause; and as nations all over the world scramble to inflate their own currencies, we may find that we have a lot of competition in the bond market.

Personally, I'm betting (and I disclose that I have put a little money where my mouth is by investing in gold-related products) that the Fed will be hard-put to time and measure the controlled deflation.

Why gold? Because, as I've said many times: You can take gold out of the standard, but you can't take the standard out of gold.

Comments

[moose3334:]

You could make the same arguements for Gold my friend.....


On Mar 20 09:00 AM User 314421 wrote:

> Oil is the new gold to protect buying power, especially if you live
> in the US since Oil is priced in dollars worldwide.
>
> Perfect inflation protection and dollar devaluation protection.
>
>
> Oil is better than gold because it is consumed and is being depleted.
>
>
> Oil reserves are falling every day.
>
> Demand may go down over time, but oil is never replenished.
>
> Eventually supply = 0 and price = infinity.

Mar 20 09:11 AM

[prudentinve...:]

......"here's the real rub, we have not practiced what Harwood calls "sound money-credit principles" since the Fed was created....."

Quite true. Had we practiced sound money-credit principles, we would not have had an oversupply of vacant houses and half-built concrete towers, not just in the US but across the world.

This is abject failure of the whole school of pop-star central banking that began with Alan Greenspan. We need responsible (and necessarily unpopular) central bankers in the Paul Volcker style to fix this mess and prevent future ones. Those who wish to be populist stars should not be entrusted with controlling the candy store (aka society's money supply).

Mar 20 09:17 AM

[reluctantQuant:]

Ever try to take a picture from a moving boat? If you get good at it, try your hand at monetary policy. When so many things are moving with complex interactions, no one has much persistent skill, regardless of experience.

Inflation - Ben would LOVE to be fighting inflation. I bet that's one of Ben's GOOD dreams, if he has any.

--rq

Mar 20 09:18 AM

[Insiderman:]

Much love for the great analysis.

"but our financial wonks at the Fed either preferred not to recognize it or couldn't prove it to their own satisfaction, at least not to a point where it would have forced them to take action. (I'd add that they may have had incentives not to want to find reasons to take that action, but that would be unfair speculation, so I won't.)"

Perhaps it's that problem with achieving FULL EMPLOYMENT consistent with price stability that causes them not to take action.

I tend to believe that the Fed was raising the discount rate full bore to stem the housing crisis, but the problem was on the supply side of the financing system (FNMA and FHLMC). In essence, those two Barney Frank widgets and their private label counterparts were injecting reserves into the system through CDOs.

Mar 20 09:29 AM

[Asbytec:]

Good article. Good points. That is in accord with theory. But, I suspect in uncharted waters, theory may not be a great guide. The economy does appear to buck theory from time to time.

Despite popular opinion, I have been pleasantly pleased with Bernanke and crew (at the same time upset with Greenspan. But, he's in good company with fractional banking, AIG, excess greed, Madoff, and unregulated CDS.) Bernanke was first to act in this crisis, in my view, back in late 2007. His testimony before congress since then has been as straight forward as one could expect.

I am not a gold bug, but I believe gold is a good investment. And I despise debasing the dollar, but events have seemed to behave contrary to theory. The dollar has, until recently, held up rather nicely manily on risk aversion. That looks set to change. And it might, but there are some other factors to consider.

Sure, US bond yields are set to fall. Sure, inflation is a bigger threat today than it was last week. The dollar has absolutely dropped through the floor in recent days. But, I suspect this is temporary.

First, we are months ahead of the EU in our recovery efforts. The EU may fin themselves in a similar QE dance with the devil in the coming months. So, the dollar relative to foreign currencies may fall for a few months then recover. We may enter (or continue) a period of volatility in the forex markets. They've been relatively flat over the past months.

Chinese currency is likely to remain pegged to the dollar for years to come, so import prices may not rise much. Who knows what oil is likely to do, but I doubt oil prices will swing wildly as the did from the wild fall from record highs.

Demand for oil is likely to remain weak for at least the end of the year (gut talking here.) Soft commodities are likely to become more volatile on investor fear of US QE. Consumer spending is likely to remain low and unemployment is likely to increase. So, a net rise in prices may not result, still...for some time yet.

It seems the drastic fall in the dollar could be investor sentiment toward lower yields. It also seems the fall in the dollar was almost equally due to fear of entering uncharted waters where theory and practice don't necessarily agree. Yet, if investors feel the US economy is likely to recover sooner, despite the fear of a lost decade or two, then the dollar may rally again and remain king.

So, while the author makes some great points, who can really say what the dollar will do once the dust settles on this bond buy out issue. Who cares if China stops buying, we'll just buy our own with our own...accountable to no body...ace in the hole: the Fed Balance sheet...LOL Interesting...

But, getting back to being pleased with Bernie and crew, I have the utmost confidence they will act to control inflation, despite themselves, at some time soon enough after it rears it's ugly head. I mean, hey, they are running the ship, who else can one have faith in? These are not pretty times that conform closely to theory. Faith they can pull it off and invest accordingly is about all we have to go on.

Okay, over 6 months ago I called a stronger dollar, despite the drop to zero and infusions of cash, and got a strong dollar. Let's see if that good ole luck holds despite the thumbs down I am likely to get on this thread. Oh, go ahead and buy gold, too. :)

Interesting and scary times, folks...good article, but could prove just as wrong as I am.

Mar 20 09:34 AM

[Jimmy in NYC:]

I agree regarding the feds inability to control deflation. But you're completely wrong on gold.

Gold standard - gold is as much a fiat as anything else. Better check your physical gold. And if you hold paper? Forget that. Might as well hold a stock certificate as well. Anybody who has watched cowboy movies or "Kelly's heroes" and other Hollywood examples knows that gold can be counterfeited with some lead and a decent shiny paint job. You won't know your gold is real until you melt it down. The key issue is trust.

Whether a fiat system or gold system or trading a bag of beans for 3 trout - it comes down to trust. And trust is shot. Period.

Mar 20 09:37 AM

[ronslim:]

On Mar 20 09:17 AM prudentinvestor
> Please do your homework on central banking. Try Von Mises Institute. Central banking is a system for robbing everyone. No fed head will ever fix the messes they create, sir.
We need responsible (and necessarily
> unpopular) central bankers in the Paul Volcker style to fix this
> mess and prevent future ones. Those who wish to be populist stars
> should not be entrusted with controlling the candy store (aka society's
> money supply).

Mar 20 09:48 AM

[billyboy54:]

Thanks to the author for one of the most thoughtful, articulate and informative articles I've read on this site (I read it daily).

I am not trained in economics or finance, and rely on articles like this to explain to me in layman's terms what's happening, and will happen, in my portfolio.

This was very helpful.

Mar 20 10:07 AM

[MGA_1:]

I'll bet the fed is going to have to eventually finance these 1.2 trillion deficits - Argentina here we come !

Mar 20 10:44 AM

[TeresaE:]

Gold?

For the average struggling American, you better start buying food and necessities.

China produces 70% of our processed foods/spices, 50% (and rising daily) of our medications, most of our first aid supplies, cleaning supplies, paper products.

China is ever so quietly raising its prices, just wait until they do not need our business anymore (soon) and see how much it costs to buy toothpaste and toilet paper.

Even if commercial property, houses, tvs and cars and salaries remain in a deflationary spiral-I suspect they will-food & basic necessities are going to skyrocket.

At the same exact time the new administration's taxes and health care/energy mandates kick in.

We are at the beginning of a long descent into the third world.

Yet we still speak of stocks and gold. You can't feed your kids with either.

Mar 20 10:51 AM

[Socialism c...:]

"Today, however, the devaluation of our currency takes place painlessly for most of us..."

Try telling that to the prudent savers and those on fixed income!! Fiat currencies and monetary manipulation are CRIMINAL!!!

Any relation to Tom, by the way?

Mar 20 12:21 PM

[Gem Hudson:]

"Get to know your business inside and out." J. Paul Getty buisness rule number two. Knowing your business inside and out is working out the business so that you know what would sell for you. You are going from your rags to your riches but spending more by buying more of a deficit death will only cost you more than what could be made in the money.

"Get into buisness for yourself." J. Paul Getty business rule number one. Because making more of the money is not only profit making, earned money is capital money because selling what is produced is making the money but print money is nothing but paper money until earned and paper money is worth nothing.

Bailing out the losers and stimulating the fools if the wealth is no longer in the dollar is to wall paper the world over in paper dollars.

Mar 20 12:37 PM

[remoran:]

It's unreal how we got into this mess. One thing I feel is totally necessary is the kill the Fed to enable the government to manage our money (I know, government is not great) because I believe Jefferson and Franklin, among others (Paul, Nader etc.) because a government that abdicates that role has no power. Fiat money or money created from nothing no longer works. Endless debt has limitations and we have reached that point. It took 90 years but we are here and nothing will be done unless the monetary policy is changed. Great article for sure.

Mar 20 12:44 PM

[Ratabulum:]

I would think that as supply approaches zero, price also approaches zero once you're past the demand destruction point. It's a bit counter intuitive, but if there was only a barrel of oil left the entire world, it wouldn't be worth very much as you would have been forced to find an alternative energy supply long before then.


On Mar 20 09:00 AM User 314421 wrote:

> Oil is the new gold to protect buying power, especially if you live
> in the US since Oil is priced in dollars worldwide.
>
> Perfect inflation protection and dollar devaluation protection.
>
>
> Oil is better than gold because it is consumed and is being depleted.
>
>
> Oil reserves are falling every day.
>
> Demand may go down over time, but oil is never replenished.
>
> Eventually supply = 0 and price = infinity.

Mar 20 01:27 PM

[AndrewBaker:]

Action required to stay solvent:

Buy gold, silver, oil, wheat, corn, soy and other commodities that are either hold their real value or are necessary to our life.

Sell the dollar.

The current action by the government will result in the buy listed items going up in cost in dollar terms, and the dollar itself losing value against other currencies.

Mar 20 02:50 PM

[nova:]

prudentinvestor wrote:
" This is abject failure of the whole school of pop-star central banking that began with Alan Greenspan. We need responsible (and necessarily unpopular) central bankers in the Paul Volcker style to fix this mess and prevent future ones."

Let me say: It is difficult to be somewhat pregnant.

As soon as any central bank starts to become "active" trying to manage economy, we have a "Centrally-Planned" economy. It is a recognized fact (except for disingenuous "intellectual" elite) that such economy lead to economic collapses and mass suffering. Soviet Union and "old" Communist China are good examples.

Soviet dictator J. Stalin always said that: "Cadres are the keys to success". Soviets tried very hard and very long to find "the right people" to run their centrally-planned economy. Unfortunately, it never worked. It brought to Soviet people famines and slavery. Consequently, Soviet gave up their socialism and are desperately trying to make their somewhat free-market economy going.

The same is basically true for China. Yes, China is still a communist country but their centrally-planned economy is gone for good.

Consequently, America does NOT need "central bankers in the Paul Volcker style to fix this mess". What American economy desperately needs is a free-market economy with minimum interference from Government, the Congress and the FED.

Let failed & corrupt banks and businesses go bankrupt opening plenty of room for successful ones to flourish creating prosperity for all.

PS
A free-market" economy is not "the Wild West". It has to function within a framework of a "lawful & civilized" society.

Mar 20 07:31 PM

[billp37:]

We admit we don't know much about econ but we read:

-----Original Message-----
From: TIAA-CREF [mailto:tiaa-cref@mess...
Sent: Friday, March 20, 2009 4:02 PM
To: [e-mail]
Subject: A Message from TIAA-CREF CEO Roger Ferguson

Dear TIAA-CREF Participant:

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While a sustained rally is unlikely in the near term, markets will eventually recover. Here are some signs of recovery that we hope to see: corporate earnings growth; rising consumption; stable housing prices; fully liquid credit markets offering an environment in which AAA-rated companies are able to borrow at normal rates; and renewed investor confidence.

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But get retirement checks from TIAA/CREF, PRU [Sandia labs],
and SOCIAL SECURITY.

Us seniors are concerned and follow posts.

Ms Delay look to be a liberal arts grad.

Caution.

home.comcast.net/~bpayne37/whitman59/w...

Mar 20 07:39 PM

[Roger Knights:]

"Anybody who has watched cowboy movies or "Kelly's heroes" and other Hollywood examples knows that gold can be counterfeited with some lead and a decent shiny paint job. You won't know your gold is real until you melt it down."

Or scratch it with a penknife, as Bogy did in "The Maltese Falcon." Actually, it's not hard to test gold--in fact this is one of the reasons it makes a good currency. All you need to test (if it's a coin) are weight and dimensions. Here are links to a thread where detection tests are described:


www.fisch.co.za/princi...
www.kitcomm.com/showth...
www.kitcomm.com/showth...
www.kitcomm.com/showth...
www.kitcomm.com/showth...
www.kitcomm.com/showth...
www.kitcomm.com/showth...
www.kitcomm.com/showth...
www.kitcomm.com/showth...
www.kitcomm.com/showth...

Mar 20 10:04 PM

[Did U Think...:]

Nice article. I especially appreciate your view that there are some assumptions the fed is making that might not turn out to be true (namely that our creditors will continue throwing money into our black hole by buying treasuries) and if these assumptions do not hold then the fed's model is bust along with any hope of undoing the inflationary effects it is causing with Q.E. Bernanke actually knows this and was signaling it to the enlightened when he said that he has an exit plan but it might not work if there is not the political will to implement it. In other words, the exit plan will unleash pain on the economy and Obama might not allow that. He might just kick the can down the road like every other president since Kennedy. Americans unwilling to take the economic pain that is clearly in store for us at some point (no matter what anyone does...) is what Bernanke was hinting at.

On a higher level, you can't get something for nothing forever, and controlled inflation is something for nothing. Inflation is the modern alchemy. But since you really can't turn lead into gold, alchemy was a scam/confidence scheme, and so is inflation. Greenspan had to admit that the fed models are imperfect recently but I will go one step further and say that they are fundamentally flawed because, and this is very key for Americans to comprehend, the fed's models are all targeted at how to achieve something for nothing. They want controlled inflation while retaining USD hegemony. Unfortunately, the system eventually becomes so dependent on this easy money that it collapses under its own weight. The best thing that can happen to a sound currency is a deflationary crash. While this is not good for the economy in the short term, it takes the credit bubble out of the money supply. If the fed will not allow this to happen then the result will eventually be hyperinflation. When the economy recovers, banks will start loaning again on top of a greatly expanded monetary base and it will create a huge amount of price inflation.

Controlled inflation is a confidence scheme by which a sovereign attempts to steal value from all holders of its currency through legalized counterfeiting. It is a scam, a flim flam which attempts to get something for nothing. It can last a long time, but eventually all scams get unwound badly. In the case of the USD, it being the world's reserve currency extends the scam to foreign countries. We extract a monstrous toll from their economies through our exportation of inflation. They are getting wise to this because our money printing continues to increase exponentially. Right now we are viewed as too big to fail but soon they will realize we are too big to bail and they will just cut their losses right along with our credit lines. They will then begin to keep a larger percentage of their own wealth and Americans will figure out that the American Dream was only possible because of the scam of exporting our inflation. When that scam fails, the dream turns into a nightmare.

So there are 3 possible endings, none of them good:
- We get a deflationary crash a-la-Prechter
- We get hyperinflation a-la-Schiff
-- OR --
- The US will start world war 3 under trumped up pretenses in order to avoid paying our debt. If that happens it will have to happen soon (within a few years) because our military is still strong with all the funding it has had available to it for the last 3 decades. As time goes on our military budget will be cut as China and Russia ramp up their militaries again. That is happening right now.

Unfortunately there is no "happy" option of returning to the good old days of US hegemony, something which delusional Americans still hope is possible.

Mar 20 11:32 PM

[Asbytec:]

There are always two sides to the story, one usually pessimistic and the other maybe not so.

biz.yahoo.com/ts/09032...

"Yet in the larger picture, many seem to be exaggerating the negative dollar implications of Fed's decision. First, while inflation expectations of monetizing the U.S. debt are a legitimate concern, dis-inflationary if not deflationary forces seem stronger than inflation, not only for this year but next year as well. Second, using the five-year/five-year forward rate, which both the Fed and ECB have cited, shows that even after the adjustment following the FOMC meeting, expected European inflation is higher than expected U.S. inflation."

And much more...

Mar 21 10:37 AM