LarryH's  Instablog

There has been a lot of debate in the media that a huge fiscal stimulus in the United States will eventually lead to hyper inflation, which would make the US Treasuries and dollar to fall. However, the dollar has been strong for a long time and it still has maintained its “safe heaven” status. Is the dollar and US treasuries really that safe? Or are the US government bonds just overpriced junk bonds? I will give some thoughts on the US economic growth, inflation and the US dollar.

As we know, prices are positively related to the total amount of money and the frequency of transactions (velocity of money) in the economy. This is known as the Quantity theory of money. In a recession, it is natural that the amount of transactions decreases, so keeping the amount of money constant, this could lead to deflation. Analogically, decreasing the amount of transactions in the economy needs to be compensated by increasing money supply in order to keep prices constant. This is what the Fed is doing at the moment - it fights against decreasing prices by increasing money supply. However, when the economic activity rises, so does the amount of transactions, which will push the prices higher. This leads to the problem that the US government will face in the near future.

When the economy starts to recover from a recession, unexpected increase in the economic activity can lead to high inflation if the money supply is not decreased at the very right moment and by the appropriate amount.
Basically, after the heavy quantitative easing and fiscal stimulus, the US policy makers cannot know when, and how much to tighten the fiscal and monetary policy in order to prevent uncontrolled rise in prices. If the government tightens its policy too early and/or too much, it can lead to even more severe recession. On the other hand, too late and/or too mild reaction can cause unwanted inflation.

I think the latter is more likely outcome, because the government wants to make sure that they will not drive the economy to a free falling again, and eventually inflation is still better option than deflation. In addition, I’m pretty sure that the US government is very reluctant to raise interest rates, because the higher interest rates will make the private debtors even more worse off. The threat of higher prices can be even more serious than expected, not only because of the extremely heavy money supply, but also due to duration of the recession. Firms have been selling off their inventories for a long time and reducing their production capacity because of the ever-lasting decrease in demand. This crisis has been the longest recession since the Great Depression. If the recovery turns out to be faster than expected, it is obvious that firms will raise their prices rapidly because of small inventories and slow ability to react to a increasing demand due to capacity constraints. This makes the importance of slow, steady and controlled recovery even more vital.

The recovery from the present recession can be expected to be slow for several reasons. Even if we forget the threat of uncontrolled inflation, it is reasonable to assume gradual growth at least for the following reason. The US public and private debt is so enormous, that a tighter fiscal policy is inevitable. Every debtor needs to eventually pay back the borrowed money, and so will the United States. This means that the aggregate tax rate will be higher, which reduces consumers’ disposable income and slows down the economic growth. When the US economy starts to heal, the government spending should be decreased and it should use all the disposable income to ease the debt burden. However, Obama plans to increase the government spending for a long time, for instance on a better health care system.

This scenario will definitely not support the stocks, and this applies to all highly leveraged countries, such as UK. Even though the US fell first into the recession, it might not be the first who recovers from it. It is very likely, that the rich countries such as China, are the best performing economies in the near future. Even though the US has had a big influence on China’s economic growth through massive imports, I believe that China (among the other emerging Asian countries) have the possibilities to become a one of the biggest growth engines of the world.

How about the dollar? For a long time, the dollar is considered as a “safe heaven currency“, because the increasing risk aversion drives investors to buy the US treasuries. This has led to the stronger dollar during the crisis, but lately it has started to weaken. As the fear of inflation is rising its head, the dollar may not be the safe heaven anymore. Higher inflation expectations raise the Treasury yields, because investors demand higher risk premium for their investments. If interest rates are kept constant, this could result in even negative real returns. In normal circumstances, the Fed would raise interest rates to slow down the rising prices, but in a highly leveraged and slow growing economy, this could be disastrous. Higher interest rates would push the home prices off the cliff again, and the economy would be closer the deflation, which is highly unwanted. This means that if the inflation expectations rise, it will result in low real returns and dollar to devaluate when investors are selling their US assets. At the moment the Fed is buying a huge amount of US Treasuries to keep the long term yields low, which prevents the price of US Treasuries from falling.

The same reasoning applies against the argument that the US will inflate its government loans and reduce the real value of public debt by accelerating inflation. It just makes no sense to push inflation higher. Without increasing interest rates the dollar would fall and China wouldn’t be cheering. Higher interest rates don’t seem possible without strong economic growth, which I can’t see coming very soon. Higher interest rates would also hit hard the highly indebted private sector.