Thursday, November 11, 2010

How Did We Return To The Brink of 1970s Stagflation?

You sit up and take notice when people as diverse as economist Alan Reynolds, former Reagan Treasury official Bob Zoellick, and former Alaskan Governor Sarah Palin decry, the latter two in the same edition of the Wall Street Journal, the Fed's QE2 policies for stoking inflation.

Palin's remarks demonstrated a surprisingly firm and clear understanding that Helicopter Ben's recent QE2 monetization of Treasury debt is weakening the dollar, thus driving dollar-denominated prices of commodities skyward.

Add to this Alan Meltzer's Journal editorial a week ago, entitled Milton Friedman vs. the Fed, and you should really be worried. Meltzer began his piece,

"Some people, including this newspaper's David Wessel in a column last week, believe the great Nobel laureate would favor this inflationary program. I am certain he would not.

Friedman's main message for central banks was to maintain a monetary rule that kept the growth of the money supply constant. In his Newsweek column, "Inflation and Jobs" (Nov. 12, 1979), for example, Friedman emphasized that "unemployment is . . . a side effect of the cure for inflation," so that if a central bank "cured" unemployment by inflating, it "will have unemployment later." In other words, don't try it."

That's what I recall from my undergraduate economics courses, as well. Friedman was famous for eschewing any active currency creation, instead, legislating some constant rate of growth of the currency, perhaps related to population or GDP growth rates.

On the subject of inflation measurement and expectations, Meltzer helpfully wrote,

"In the late 1980s, former Fed Chairman Alan Greenspan encouraged everyone to watch the core deflator for personal consumption expenditure—the PCE deflator. Since then, the Fed has used that measure as its inflation target. Recently, without much publicity, the Fed switched to the consumer price index (CPI). The reason? From 2003 to 2009, the two measures moved together. In 2010, they diverged—and the CPI shows substantially less inflation than the PCE.

Even so, the most recent PCE deflator shows inflation running at around 1.2% annually, about where the Fed says it wants to hold the inflation rate. And it has been between 1.5% and 1.8% for a year. There is no sign of deflation.

The two measures diverged because they give different weights to their components, especially housing prices. The CPI gives almost double the weight to housing prices, especially the rental value of owner-occupied houses. This is not a number that government statisticians sample in the market. They make an estimate. The new long-term bond purchase program puts a lot of weight on a weak foundation.

Paul Volcker and Alan Greenspan restored much of the credibility that the Fed lost in the great inflation of the 1970s. The Fed's plan to increase inflation puts this credibility at risk and is a large step away from the policy that Milton Friedman favored."

So we see that the Fed has been playing fast and loose with measured inflation, while somewhat unbelievably declaring that the current risk to the economy is deflation. I distinctly read of Bernanke's recent comments about how slack labor markets virtually guarantee no imminent inflation. This while commodity prices such as copper, corn and oil spike to new highs, thanks to global perceptions of the administration's and Fed's weak dollar policy.

Can anybody say "stagflation?" Art Laffer wrote a Journal editorial just over a year ago, on which I wrote this post. He rather eerily foresaw what is now occurring. A few years ago, I dismissed some pundits' fears of stagflation, because, then, monetary policy-induced inflation wasn't yet evident. It is now.

I well recall, though young at the time, the decade of monetary policy incompetence delivered by Fed Chairmen Arthur Burns and G. William Miller. They presided over the monetary half of US stagflation, while LBJ's Great Society spending, combined with the Vietnam war, provided the fiscal half.

Is it really that possible that we've learned nothing from that era, as well as, per Laffer's editorial, the 1930s? What more evidence is needed for the Fed and Congress to understand where their joint policies are headed?

Only, this time, global interests and ubiquitous information make reactions near-immediate and much more damaging. As significant as our deficits and foreign-held debt were in the 1970s, they are far larger now. And today's global economy is much more multi-lateral than it was forty years ago.

Reynolds notes this in his recent Journal editorial, Ben Bernanke's Impossible Dream, in which he uses an EFT which ultra-shorts Treasuries, TBT, as a barometer of market reaction to Fed moves,

"Producer prices rose at an annual rate of 5.5% in September and 4.8% in August. The broad price index for GDP rose at an annual rate of 2.3% in the third quarter, up from 1.9% in the second quarter and 1% in the first.

Mr. Bernanke is unconcerned, however, because he believes (contrary to our past experience with stagflation) that inflation is no danger thanks to economic slack (high unemployment). He reasons that if people can nonetheless be persuaded to expect higher inflation, regardless of the slack, that means interest rates will appear even lower in real terms. If that worked as planned, lower real interest rates would supposedly fix our hangover from the last Fed-financed borrowing binge by encouraging more borrowing.

This whole scheme raises nagging questions. Why would domestic investors accept a lower yield on bonds if they expect higher inflation? And why would foreign investors accept a lower yield on U.S. bonds if they expect exchange rate losses on dollar-denominated securities? Why wouldn't intelligent people shift their investments toward commodities or related stocks (such as mining and related machinery) and either shun, or sell short, long-term Treasurys? And if they did that, how could it possibly help the economy?

On Oct. 15, Mr. Bernanke gave another speech, at the Boston Fed, saying, "Inflation is running at rates that are too low . . . and the risk of deflation is higher than desirable." TBT rose again to 34.17, up from 33.34. On Nov. 3, when the scope of the Fed's long-term Treasury purchase plan was revealed, TBT jumped from 32.69 at 2:12 p.m. (EST), just before the news was released, to 34.99 by 3:34 p.m. (TBT closed Monday at 34.99.) If the Fed's plan really portends a sustainable reduction in long-term rates ahead, TBT should have moved in the opposite direction. When technocrats and markets disagree, it is rarely wise to bet against the markets.
There is ample evidence from commodity and foreign-exchange markets that world investors are indeed confident the Fed will raise inflation. However, the growing interest in shorting long-term Treasury bonds shows that the market does not believe higher inflation is consistent with lower long-term interest rates.

In other words, Mr. Bernanke and his FOMC allies are risking higher interest rates and inflated commodity costs in the pursuit of the contradictory objectives of higher inflation and lower bond yields, seemingly oblivious to all the evidence that they are pursuing an impossible dream."

Why is it a collection of notable economists are observing, across a variety of media, that the Fed is pursuing a foolish goal which will lead to sharply increased inflation, and, yet, the Fed and Bernanke seem largely unmoved?

Now, more than any other time in history, large numbers of investors, economists and various pundits have access to historical evidence and current data to make the case that US policy makers, both monetary and fiscal, are retracing steps down a painfully familiar road to stagflation.

Yet the Fed continues on this dangerous and foolish path.

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