The Inflation Threat Is Real

From Wikipedia:

Taylor rule is a monetary-policy rule that stipulates how much the central bank would or should change the nominal interest rate in response to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP. It was first proposed by the by U.S. economist John B. Taylor in 1993.

Some have argued that according to the Taylor Rule US interest rates should be set at -5% or so to stimulate the economy. This calculation was convincing since rates are already at 0% and the economic output gap is arguably the biggest since the 1930s. [Obviously rates cannot be set at negative levels, therefore money printing through debt monetization makes up the rest.]

These estimates have provided significant leeway for monetary policy, suggesting there is a lot of room for debt monetization before inflation starts to rise. This calculation has been used to rebut forecasts for rising inflation.

However, recently John Taylor himself has stated (source: Bloomberg) that according to his calculation inflation is a significant risk, given current monetary policy.

"My calculation implies we may not have as much time before the Fed has to remove excess reserves and raise the rate,” John Taylor, a Treasury undersecretary under President George W. Bush from 2001 to 2005, said today at an Atlanta Fed conference in Jekyll Island, Georgia.

Taylor, a Stanford University professor, said the Fed’s growing balance sheet is a “systemic risk. He said his rule suggests a fed funds rate of 0.5 percent, while the central bank has cut rates to between zero percent and 0.25 percent.

Taylor's estimate [of his own rule] differs widely from many others who are looking at target rates as low as -7.5%. One reason for this is that the output gap may not be as wide as perceived. While capacity utilization rates have definitely declined, overall economic capacity has probably also declined to a permanently lower plateau. Global economic potential has arguably shrunk over the past year as we enter a period of de-globalization, re-regulation and de-levering.

If Taylor is correct, inflation could be around the corner once the output gap begins to stabilize. It will be very difficult for central banks to significantly tighten monetary policy - the political pressure will be to maintain easy-money as long as possible. Even in recovery, the wounds of the current recession will be fresh.

Moreover, with US total debt (private and public sector) at over 350% of GDP there will be tremendous pressure to keep rates low to inflate nominal GDP (to reduce the debt burden) and to keep debt service ratios low.

One only needs to look to the 1970s as an example. During the 1970s inflation pressure built up over 10 years, and only after a crash in US Treasuries became imminent did the Federal Reserve significantly tighten policy.

Position your portfolios early to protect from inflation.

Comments

[Dave Wrixon:]

I wouldn't worry about any of that until they come up with a reliable method of measuring it in the first place. The existing statistics consistently and probablly reliably underestimate inflation, which is one of the reasons that interest rates have been too low for a decade. It has also explained why GDP has apparently been growing whilst life for the average American gets harder year by year. Much of the growth has always been misreported inflation. Now any of the inevitable deflation of the dollar can just be added to the inflation rate, or perhaps the GDP, unless interest rates are hiked up dramatically to restore equilibrium. Low interest rates were never a viable solution to this problem. All they have done is allowed Uncle Sam to borrow cheap money, which is just being squandered.

May 21 09:37 AM

[EUARTE:]

Low interest rates got us into this monetary mess. We are to believe that printing presses and 0% rates will get us out. I am having a meltdown.

May 22 10:34 AM

[TheReaper!:]

On the edge of a Deflationary abyss ...........OR ?

On the edge of a Deflationary abyss , worrying about hyper inflation ? One foot in a Great Depression , screaming unemployment , global capacity utilization at all time lows , factories shutting down all over the world , real wages falling , retirees wiped out looking for jobs etc etc .

And we're worrying about hyper inflation ?

The key word here IMO is DEMAND ! Yeah yeah , I know all about printing money and the Weimar Republic . My question is how do we get to hyper inflation , when the world quit buying stuff even at fire sale prices ?

I guess any thing is possible , especially in this crazy screwed up world we now live in . That said it seams to me it would be hard to get people to buy things at even higher prices , when they don't want them at lower prices . Eventually years from now when the gluts are long gone , maybe some one could successfully raise prices . IMO if this commodity run we now find ourselves in takes off , it will just push a lot more businesses out of business . Like I said above , if they can't sell all this stuff at fire sale prices , how on earth are they going to pass on these higher cost ?

Explain that ! ...................The...

May 22 05:45 PM

[CLH:]

There is little or no chance of hyperinflation during a credit crisis. It would be a first. As debt is eliminated, money is destroyed. The amount the govt. spends will not make up for this. The answer is war which got us out of the 1930s debt crisis, but we dont want that.

Short term spending (like war is good) but long term will destroy the country. No social programs should be started.

May 23 07:55 AM

[Plan B Econ...:]

A couple comments:

1. There was no mention of hyperinflation.

2. The inflation threat doesn't mean inflation is forecast to rise tomorrow. We're talking about 12-24 month horizon. But inflation can runaway once central banks lose credibility.

3. Inflation may or may not manifest in CPI. CPI has a misleading history. But take a look at the depreciating USD, tuition costs, food costs, energy costs, health care costs, commodity prices...look at the cost of living as a % of disposable income...as a % of total financial wealth.

4. Aggregate demand can flatline and inflation can still exist. Just double the money supply. If inflation due to money supply wasn't a concern then the US Fed could simply print a $1,000,000 bonus for every citizen in the US and simply start handing out checks.

May 25 10:22 AM