Last week we wrote an article about the 'hard money' versus 'soft money' debate within the context of central banks like the Fed, the ECB and the BoJ buying assets, and how that might work out. Here is the context:
- Normal business cycles can usually be smoothed with monetary policy.
- However, the present situation isn't a normal recession where lower interest rates will do the trick, but instead is a 'balance sheet' recession, brought about by households and banks cutting borrowing and spending; paying off debts in order to repair balance sheets.
- Also, interest rates cannot be lowered any more by the Fed; they're effectively zero. Fiscal policy (the obvious candidate to revive the economy) isn't available because of political deadlock.
So with fiscal policy out of the equation, the choice is basically between doing nothing and having the Fed embark on more unusual measures, like buying longer dated assets (that is, quantitative easing or QE). The hard money people are dead set against such measures.
To their credit, the hard money guys like Peter Schiff and Ron Paul accept the consequences of this, which is letting the recession run its course (insofar as they don't actually want to raise interest rates). We think this would be unwise, for a number of reasons:
- The deleveraging process can easily turn into something very nasty, that is, a Fisherian debt-deflationary spiral in which downward shifts in demand, production, employment, asset prices and expectations can feed on themselves, especially if banks fall over as a result. This happened on a large scale in the 1930s, and is happening right now in Spain. Again to his credit, Ron Paul accepted this in the midst of a primary debate running for office, a rather brave stance.
- This becomes even nastier if prices start to fall. The real burden of debt rises when that happens, and it is quite difficult to get out of (ask the Japanese). Very puzzling to us, hard money people like Schiff and Paul actually welcome deflation.
- An economy accumulates real damage to the supply side if it produces way below its productive capacity for a prolonged period of time. Plants become obsolete, investment is insufficient, long-term unemployment rises, and these workers lose skills and employability.
The hard money people believe that QE is inflationary. We think under the present circumstances, there is very little risk of that. There is still ample spare capacity and high unemployment. Although the deleveraging might be quite advanced, it isn't finished, so demand is subdued.
People who warn about hyperinflation in Weimar and Zimbabwe should really pay attention to what happened there. First Weimar:
Turns out it was those pesky war reparations that caused government deficit spending to soar to something like 50% of GDP annually, with most of that whopping deficit spending used to sell the German currency and buy foreign currency to pay their war reparations. [Creditwritedowns]
Turns out they had a tad of civil unrest that dropped their productive capacity by about 80%, but government spending stayed high and too much spending power with too few goods and services for sale drove prices through the roof. Not to mention rumors of insiders using the local currency to buy foreign currencies for personal gain (sound[s] familiar). [Creditwritedowns]
Is this really what is happening in any developed country right now? Not even close. To replicate these experiences:
Applying this to the US to replicate the Weimar inflation Congress would have to increase the deficit to about $8 trillion a year and then sell those dollars continuously in the market place, using them to buy the likes of yen, euro, and pounds. And replicating Zimbabwe would mean some kind of disaster that wiped out 80% of our real productive capacity and then continuing to spend federal dollars as if that never happened. [Creditwritedowns]
Evidence so far shows little if any accelerating inflation. In the UK, the Bank of England has embarked on several QE programs, together accounting for some 25% of Britain's GDP. Yet inflation is falling. In Japan there is deflation, despite years of QE (and even more years with very large public deficits and debts). In the US there isn't much, if any, uptick in inflation either.
Having failed to materialize after years of warning, this should be discomforting for those warning about the inflationary impact of QE. Some resort to arguing that the inflationary statistics are doctored by the government. Does that include the governments in Japan and the UK, we wonder? The million prices website is entirely consistent with the consumer CPI, so we're not buying that one.
Others point to the rise in the price of gold as evidence of "currency debasement." So what? If the terrible inflationary consequences of QE are only showing up in the gold price, then what's the problem? And the rise in the gold price might just be a simple self-fulfilling prophecy. Which brings us to the role of expectations.
People who fear inflation as a result of "money printing" seem to have too simple a grip on the exact transmission mechanisms of QE. QE mainly works by increasing bank reserves (in that way it isn't really different from 'normal' monetary policy at all). But these will only add to the money supply if banks lend more.
Since banks are generally not reserve constrained (especially not now), pumping them full of additional reserves isn't likely to have much, if any effect on credit (and hence) money creation. The suppression of long-term interest rates through the Fed buying of long-term assets isn't likely to do much either.
Mortgage rates are at record lows and the current rate for a 30-year fixed mortgage stands at 3.34%, according to Zillow Mortgage Rate Ticker. But banks are approving fewer loan applications and have tightened lending standards, resulting in a delayed housing recovery. [Yahoo]
Or, in the words of Baker, a senior research fellow at Harvard University's Joint Center for Housing Studies:
More quantitative easing "will help a little" but mortgage rates are not holding back the market," Baker says. "Banks are nervous to get back in this market and low rates won't change that dramatically." [Yahoo]
So housing and bank lending aren't going to be moved a whole lot. But there is a third transmission mechanism.
QE could increase inflationary expectations. Higher inflationary expectations could spur the recovery in several ways:
- Lead to spending directly (as waiting will make stuff more expensive)
- Lower real rates
The latter is especially important as nominal rates at the short end are 'zero bound,' that is, they can't be lowered anymore. One way to measure this impact on inflationary expectations is to look at the TIPS spread, the difference between the interest rate on ordinary 10-year bonds and inflation-protected securities:
And indeed, there seems to be an effect; inflationary expectations have gone up. Has this lowered real yields?
You see that real yields are very low already, even negative for the 5 and 10 year bonds, and the impact of an expected QE3 is visible especially in the five year maturities. Is this a panacea? No, and it isn't entirely without risk either. Although the present inflationary climate is rather benign, inflation expectations can become ingrained though.
This isn't likely to happen anytime soon (we need actual inflation to rise as some sort of confirmation for the expectations). However, inflationary expectations are a variable that react to real inflation with a substantial lag, that is, they have a considerable degree of 'path dependency.' It's like an ocean tanker, very difficult to change course, but once changed, there is considerable momentum.
We understand that the Fed has to do something with fiscal policy in deadlock and conventional monetary policy having little traction due to deleveraging and the zero bound of interest rates, but inflationary expectations are a difficult variable to control. It's too early to start worrying about this potential problem when we are faced with all to manifest real problems, but it's definitely something to keep in mind later on.