Page 1 of 3 CREDIT BUBBLE BULLETIN Inflationphobia
Commentary and weekly watch by Doug Noland
The melt-up continues. Federal Reserve chairman Ben Bernanke on July 10 buttressed global markets with his "If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that" comment.
In last week's congressional testimony, he followed up his market-pleasing ways with a notably dovish spin on the inflation outlook. Bernanke is now signaling that extraordinary monetary stimulus is in the cards until inflation "normalizes" back to the rate-setting Federal Open Market Committee's 2% target rate. The markets
can also rest assured that he's prepared to significantly boost the US$85 billion quantitative easing (QE) in the event of a downside inflation surprise. From my analytical perspective, there are strong arguments that an inflation rate is an even a poorer data point than unemployment for basing the scope of aggressive experimental monetary stimulus.
So expect the inflation discussion to become even more topical. Bruce Bartlett is in the middle of a series of "Inflationphobia" articles for the New York Times. He compares classical economists to "generals and admiral ... always fighting the last war... " with "strategies that are inherently out of date".
Economists learned from the Great Depression that easy money and fiscal stimulus could stimulate growth. Pre-Depression classical economics had been based on a rigid balanced budget requirement for government and a gold standard that provided no discretion for the monetary authorities. The new economic orthodoxy became associated with the theories of the British economist John Maynard Keynes and came to be called Keynesian economics. Supporters of classical economics were relegated to the sidelines of economic discussion, but they never went away...
Fortunately, the Fed was led by Ben Bernanke, whose expertise as an academic economist was the Great Depression. He knew that the Fed's errors had contributed mightily to the depression's origins, length and depth, and resolved not to make the same mistakes twice... But the classical economists, whose ranks were much strengthened by the failure of Keynesian economics in the fight against inflation and the apparent triumph of classical policies in the 1980s and 1990s, immediately saw an inevitable replay of the 1970s. They were fighting the last war... While the Fed has generally maintained an easy money policy, inflation has remained dormant... But the constant drumbeat of attacks on the Fed for fostering inflation has constrained its actions, condemning the economy to slower growth and higher unemployment than necessary.
And from last week's "Inflationphobia, Part II":
Last week, I discussed the phenomenon of inflationphobia - an irrational fear of inflation that is constraining the Federal Reserve and holding back the economy. The roots of inflationphobia go back at least to the Great Depression, when inflationphobes made the same arguments year after year despite continuing deflation - a falling price level. The defining characteristic of the Great Depression was deflation, which began in 1927, two years before the stock market crash... The great economist Irving Fisher thought that the increasing real burden resulting from deflation was the core cause of the Great Depression.
Irving Fisher was a great economist who was oblivious to the Roaring Twenties bubble. He famously stated that American stocks were at a "permanently high plateau" days before his wealth was destroyed in the 1929 stock market crash. He went on to write seminal analysis on debt deflation and financial crisis that contemporary economists still use to justify inflationary monetary policy. More appropriately, his work would be used as a warning of the perilous risks associated with credit booms, speculative bubbles and bubble economies.
I have a few issues with the current "inflation" "debate". As I've noted previously, it's misguided to compare the current backdrop to the Great Depression. If anyone is mistakenly "fighting the last war", it's the Bernanke Federal Reserve and inflationism more generally. Second, it is equally misguided to focus the "inflation" discussion simply on an aggregate measure of consumer price inflation. For one, it shouldn't be ignored that some of contemporary history's greatest bubbles were inflated during periods of seemingly benign consumer prices (notably, the Twenties and Japan 1980s) bubble
I had the good fortune of being introduced to the Richebacher Letter in 1990 and had the opportunity to assist the great German economist, Dr Kurt Richebacher, with his monthly publication for a number of years back in the '90s (and somewhat beyond). He was certainly no "classical" economist. The so-called "Austrians" just have a superior conceptual framework when it comes to analyzing inflation and inflationary processes.
For me, the primary focus on credit always resonated. An expansion of debt - "credit inflation" - will have consequences, although the nature of the inflationary effects can differ greatly depending on the nature of the underlying credit expansion, the particular prevailing flow of the new purchasing power and, importantly, the structure of the real economy (domestic and global). The increase in purchasing power may or may not increase a general measure of consumer prices. It might be directed to imports and inflate trade and current account deficits. It may fuel investment. Or it could flow into housing and securities markets - perhaps inflating asset bubbles.
Dr Richebacher persuasively argued that rising consumer price inflation was the least problematic inflationary manifestation, as it could be rectified by determined (Volcker-style) monetary tightening. Presciently, Richebacher viewed asset inflation and bubbles as the much more dangerous inflationary strain - too easily tolerated, accommodated or even propagated.
It's no coincidence that periods of low consumer price inflation preceded the Great Depression and the bursting of the Japanese bubble. I would further note that consumer price inflation was relatively contained prior to the bursting of the tech and mortgage finance bubbles. But to claim this dynamic was caused by tight monetary policy is flawed thinking. It was just the opposite.
I would argue that major monetary inflations, along with attendant investment and asset bubbles, tend to boost the supply of goods and services. Myriad outlets arise that readily absorb inflated spending levels, working to avail the system of a rapid increase in aggregate consumer prices. Booming asset markets become magnets for inflationary monetary flows, while a boom-time surge in more upscale and luxury spending patterns also works to restrain general price inflation. Moreover, a boom in trade and international flows ensures strong capital investment and an increased supply of inexpensive imports (think China, Asia and technology).
The thrust of the analysis is that low consumer price inflation has been integral to central banks accommodating the most precarious credit bubbles. I've always been leery of the notion of "inflation targeting", believing that such an approach risked institutionalizing central bank accommodation of credit excess and asset inflation. Bernanke's recent focus on below target inflation and potential market tightening of "financial conditions" has been music to the ears of a speculative marketplace. The markets hear a nervous Fed providing assurances of aggressive intervention in the event of marketplace de-risking/de-leveraging. Especially in a high risk backdrop, such talk can significantly alter market risk perceptions.
I'm not afflicted with inflationphobia. Instead, I have a rational aversion to credit and speculative excess. At this point, it should be obvious that a huge issuance of mis-priced debt is problematic. Central banks should avoid accommodating speculative leveraging. The Fed should be very leery of engineering market risk (mis)perceptions. After all, we have witnessed a more than two-decade period of serial global booms and busts. The Fed believes we're in a post-bubble environment, although officials have repeatedly stated it's not possible to recognize the existence a bubble while it's inflating. Then isn't it dangerous to embark on an experimental monetary inflation, especially when the Fed is devoid of a framework that would prevent it from again accommodating dangerous financial bubble excess?
The structure of the consumption and services-based US economy has evolved over the years to easily absorb credit excess with minimal impact on the consumer price index. After dropping to as low as $25 billion during the 2009 recession, the monthly US trade deficit recently jumped back up to $45 billion. China and Asia can these days produce quantities of iPads, smartphones and tech products sufficient to absorb enormous amounts of purchasing power (this doesn't even include downloads!). That a large proportion of the population is stuck with stagnant income also works to keep consumer inflation in check. As always, the late phase of credit booms sees inequitable wealth redistribution and a small segment of the population enriched by outsized gains.
There's another side to the seemingly placid US inflationary backdrop. For the past 20 years, Federal Reserve accommodation has been instrumental in unending booms and busts around the globe. In contrast to the US, the structure of the developing economies is generally much more susceptible to destabilizing inflation dynamics. We're now five years into a historic inflationary cycle in China and throughout many developing economies. The deleterious inflationary consequences have reached the point that a strong case can be made that this spectacular bubble period has begun to falter.
As I've stated repeatedly, I believe the fragile global backdrop at least partially explains the Fed's determination to stick with aggressive monetary stimulus. Importantly, with much different financial and economic structures, EM officials do not today enjoy the Fed's luxury of easily sustaining their respective booms. China, Brazil, India and others now face a market-based tightening of financial conditions, while various consequences of a protracted inflationary cycle preclude another round of aggressive stimulus programs.
The global economy is increasingly vulnerable to the downside of the emerging market (EM) credit cycle. With abundant liquidity courtesy of Fed and Bank of Japan QE, there still remains ample fuel to worsen the wide divergence building between economic fundamentals and securities prices. All bets are off in the event of market de-risking and de-leveraging.
Yet when "risk on" is in play, it becomes a game of betting on which markets provide the strongest magnets for speculative flows (and Fed/BOJ liquidity). Faltering developing markets may be a significant risk to the global economy, yet it also provides a competitive advantage to US and Japanese equities bubbles. Meanwhile, cracks in the US and global "bond" bubble - while negative for global growth - also lend short-term support to US stocks in this game of performance-chasing, trend-following and bubble-inflating speculation.
Whether the Fed recognizes it or not, it's now fully immersed in the stock market bubble blowing business. Things got crazy in 1999 - when investors/speculators disregarded deteriorating industry fundamentals and technology stocks launched into a final moonshot. The Nikkei went crazy in 1989 in the face of troubling Japanese fundamentals. US stocks went nuts in 1929 despite rapidly deteriorating global fundamentals.
As fundamentals begin to deteriorate, this naturally leads to increased hedging and more bearish bets. Both provide latent market melt-up fuel. Central banks need to be mindful that their interventions will likely spark destabilizing short squeezes, the reversal of hedges and the potential for intense speculation. Instead - and this seems particularly the case during periods of perceived acute market vulnerability - the Fed is keen to spur market rallies and disregard bubble risks.
The Fed made a grievous mistake when it used a mortgage credit boom to orchestrate post-tech bubble reflation. The Fed's aggressive interventions in 2007 and early-2008 stoked late-cycle market excess (ie $145 crude and highly correlated global risk markets) that ensured a worse outcome in late-2008. I believe a bigger mistake was committed when the Fed targeted rising stock, bond and risk asset prices for its epic post-mortgage finance bubble reflation.
More from Mr Bartlett's "Inflationphobia II":
In an editorial probably written by Mr Hazlitt, The Times rejected any resort to inflation no matter how much prices fell. "The one thing your inflationist cannot have too much of is inflation," the editorial said. "Give him one dose and he becomes much more emphatic in his demands for another." In other words, it's always a slippery slope - a little inflation today invariably leads to hyperinflation tomorrow. If economic stagnation and high unemployment result, it's a small price to pay to avoid something worse, the inflationphobes always assert.
Henry Hazlitt had a much clearer understanding of inflation than contemporary economists. Throughout history, inflation has repeatedly proved itself a "slippery slope" - so slippery the Fed and most pundits don't even realize we've been sliding.
At $2 trillion, the Fed had constructed a reasonably well-defined "exit strategy" that it was to implement to normalize its balance sheet. Now, briskly on the way to $4 trillion, the Bernanke Fed is adamant in signaling to the markets that it is determined to avoid normalization. In the most gingerly way imaginable, the Fed recently signaled its intention to, in coming months, begin cautiously backing off from $85 billion monthly QE. Well, the markets threw a fit and the Fed abruptly back-peddled.
That's right: "Give him one dose and he becomes much more emphatic in his demands for another." And "he" would be stock and bond market bubbles, the gigantic global speculator community, the maladjusted US economy, the highly distorted global economy and financial "system", and so on. With massive monetary inflation today having little impact on economic stagnation and high unemployment, resulting market bubbles and worsening imbalances are a high price to pay.