Poet Laureate Robert Frost is among the best known American poets. Although he died in 1963, he is the poet of this financial crisis. His Roaring Twenties poem "Fire and Ice" is about how the world may end and also captures the two scenarios of consequences of the crisis.* Fire is inflation. Ice is deflation.
Many, if not most, fear the consequences of the expansion of the Federal Reserve's balance sheet and that the prospect of hundreds of billions of dollars in new government debt will lead to inflation. Debtors typically prefer inflation and the US government is taking on huge liabilities, increasing the budget deficit and the debt levels. The risk, they say, is that the debt will be monetized over time, which is to say that, in essence, the US will just fire up the printing press and print more fiat money. Some measures of inflation expectations did rise. Fed officials have often cited the five-year-five-year forward as one of the measures of inflation expectations it tracks. It is a comparison of a 5-year forward of a 5-year Treasury Inflation Protected Security (TIPS) and a conventional Treasury note. The five day average went from 2.27% on Sept 17 to 2.66% on Sept 22.
The US yield curve has also steepened sharply. Over the past week, the 2-year to 10-year curve has steepened by 14 bp to 179 bp. This is twice the pace of steepening seen on average over the past three weeks. Gold, often identified as an inflation hedge, rallied by nearly 25% in six sessions around the middle of the month. The demand for gold has been particularly acute, acute enough for the US government to "temporarily" suspend the sales of the popular American Buffalo one-ounce gold coin after running down its inventories. The US Mint reported that it sold 164k such coins since January, which is around 54% more than the same year ago period. Last August, the US Mint had to suspend sales of its American Eagles one-ounce gold coins and later to limit the number of shipments to dealers. Since last January, the US Mint has sold nearly 420k of these gold coins, which is more than twice the 2007 full-year total.
The fear of inflation is palpable, but the threat of deflation is also real. This is the Japanese scenario. A real estate bubble pops, leading to a banking crisis as real estate loans sour. Officials respond by flooding the system with money. Banks hoard the funds and officials are left pushing on the proverbial string. If Frost is the poet of the crisis, then Hyman Minsky is its economist. Minsky argues that a long period of rapid growth, low inflation, and macro-economic stability breeds complacency and encourages excessive risk taking. He shows how and why stability leads to instability. Banks already appear to be hoarding the liquidity the Federal Reserve is providing. The latest two-week reserve period that ended September 24 showed that excess reserves averaged almost $69 bln a day, which is roughly twice the previous record set around 9/11.
Deflationary forces also pose a risk to the real economy. The US economy contracted in Q4 07, but expanded at a below trend pace in the H1 08. The risk of contraction in H2 08 has increased. The paralysis in the capital markets and the rising cost of capital for businesses, rising unemployment, and weakness in domestic demand may very well lead to the first back-to-back quarterly contractions in US GDP since the Q4 90-Q1 91 period, which featured the first Gulf War and the S&L crisis.
Doom and Gloom
Ironically, whether by fire or ice, many say the dollar will be undermined. Under the inflation scenario, a cheaper dollar may make it easier for the government to repay its debt. However, both domestic and international investors will demand a high yield to compensate for the currency risk. Under a deflationary view, the central bank will have to pump even more money to the banking system. Bernanke has derisively been called "Helicopter Ben" and this comes from when he was a Fed governor suggesting that to combat deflation, a central bank could drop currency from a helicopter to debase it.
The pendulum of market sentiment has swung hard away from a rate hike that the market had flirted with and toward a rate cut. Recent comments from Bernanke seem to reflect a growing concern about the downside risks to growth. The Fed funds futures strip has an October rate cut and a December rate cut nearly fully discounted in current prices. In addition, given the financial stress, bringing down the discount rate to the Fed funds rate, as the Greenspan Fed did during the S&L crisis, seems likely.
Some Fed officials have resisted this step because they argued that it would be more difficult to target the Fed funds rate. Yet the financial crisis and the expansion of the Fed's balance sheet is already making Fed funds (the effective rate, which is a weighted average of transaction rates) quite volatile.
There are a couple of considerations that may help blunt the negativity and pessimism. Bank credit is still expanding. The data is reported on a monthly basis, and next week's report for the month of September will be important, but here is what it looked like through August (and can be found on the St. Louis Fed web site): Commercial and industrial loans are were up about 25% from a year ago at $1.5 trillion. Real estate loans were up about 5.8% from a year ago at $3.6 trillion. Loans to consumers are up about 14.5% from year ago levels at $845 bln.
Money supply, as measured by M2, which includes M1 currency held by companies and individuals and adds money market mutual funds, has risen at a 5.2% pace over the past year. The Federal Reserve does not target M2, but this pace is above the upper end of its previous desired range. The pace is also above nominal growth rate. During its deflationary crisis, Japanese money supply often contracted. That said the 5.2% rate is the slowest not only of this year, but the slowest pace seen in the US since early 2007.
Also recall that after the 1987 equity market crash that saw a quarter of US market cap wiped out in a single day, there was no recession, despite the fears of one. The recession did not come for several years. The resilience of the US real economy to the events on Wall Street is remarkable. Another mitigating factor is that as Nixon infamously said, and Reagan, Bush-the Elder, Clinton, and Bush-the-Lesser tried to refute by deed, "We are all Keynesians now." Counter-cyclical spending and the remainder of a social safety net may help limit protect Main Street from the full impact of the crisis on Wall Street.
Fire and Ice - by Robert Frost
Some say the world will end in fire;
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate<
To say that for destruction ice
Is also great
And would suffice.