More Reasons to Worry About Inflation

Many deflationistas believe that the wealth being destroyed by the bursting of the global credit bubble will swamp the money being created by fiscal and monetary authorities for the foreseeable future, thus eliminating the threat of inflation, at least in the near term.

But what they seem to be discounting is the effect that a contagious loss of confidence can have on the value of a fiat currency, which is, after all, dependent on the continued faith of those who accept it as a medium of exchange and a store of value.

If, for example, enough people start to believe that a government is embarking on road-to-ruin economic policies, hordes of those who hold the currency may suddenly start stampeding for the exits, altering the supply-and-demand equation and leading to a contraction in its purchasing power.

In "Inflation Prospects In An Emerging Market, Like The U.S.," Baseline Scenario's Simon Johnson highlights circumstances where changing demand stemming from altered perceptions might spawn a serious inflation problem.

There are two ways to think about inflation in today’s economy. The first, suggested by conventional macroeconomic frameworks for the US, is that, with rising unemployment and actual output sinking further below “potential” output, inflation will stay low - and we could actually experience the dangers of falling wages and prices (think what happens to mortgage defaults in that scenario). This is the view, for example, expressed by Fed Vice Chair Don Kohn last week, and the Obama Administration seems to be on exactly the same page - talking already about a further very large fiscal stimulus.

Some people in this camp do see a danger of inflation, down the road, as the economy recovers - and resumes its potential level (or growth rate). As a result, many of them stress that the Fed will need to start “withdrawing” its support for credit and raising interest rates as soon as the economy turns the corner. One informed insider’s reaction to our piece on Ben Bernanke in the Washington Post on Sunday was that we were too easy on Bernanke for failing to tighten monetary conditions as the economy began to recover after the last big easing earlier this decade (specifically, our correspondent argues that Bernanke provided the intellectual underpinnings for what Greenspan wanted to do.)

In today’s post-G20 summit situation, some of my former IMF colleagues are worried that further monetary easing around the world will create inflationary pressure in middle-income emerging markets, where inflation is often harder to control than in richer “industrial countries.” But if you think the broader political and economic dynamics of the United States have become more like those of emerging markets, e.g., the concentrated power of the financial elite and their ability to access corporate welfare, doesn’t that also have potential implications for inflation?

In discussions of emerging markets, you rarely hear discussion of “potential output.” This is a slippery concept even for the United States, with origins in the idea of running factories at “full capacity” but also reflecting the traditional bargaining power of labor - macroeconomists argue about the exact reasoning but most agree it’s a magical place where inflation is stable. If output (or growth) is too high relative to potential, inflation rises and, depending on where you are relatively to some sort of inflation goal, the central bank needs to tighten monetary policy in order to bring it down.

Emerging markets traditionally experience big movements in relative prices (e.g., entire sectors collapse), big ups and downs in credit (i.e., regular banking crises and recoveries), and waves of government bad behavior (think expropriation of people’s pensions or other assets). Potential output simply isn’t stable, or perhaps even measurable, in situations with a lot of investment (in good times) and much disinvestment or scrapping of capital (when times turn sour).

So what determines inflation in emerging markets? This is simple, but also very hard to manage: the balance of supply and demand for money. The government issues money through its financing of budget deficits and various credit-support operations; this obviously tends to push up inflation (i.e., more money tends to reduce the value of money outstanding). People’s demand for money depends on what they expect in terms of inflation, and this is often affected by what the exchange rate is doing - a depreciating currency both raises the prices of imports directly and moves people’s inflation expectations upwards. In the background, of course, a growing economy has an increasing demand for money, so the economy can handle - and perhaps even needs - money issue. In practice, policymakers watch the inflation rate like a hawk and move rates up or down accordingly - but subject to the political pressures coming from higher or lower growth, perhaps relative to their perception of “trend” but without reference to any kind of “potential” concept.

What kind of economy is the US today? The financial sector has taken a huge hit and is almost certainly going to contract. The credit system remains disrupted and levels of investment are almost certainly down across the board. Many firms, nonprofits, and consumers overexpanded relative to what they now see as their more permanent prospects, so there is a big move to “repair balance sheets” (pay down debt; invest less). Potential output, if that is still a meaningful concept for the US, must be falling; and potential growth (based on some idea of where productivity can go) must also be down.

Even more important in the short-run, inflation expectations are on the move. There are different ways to think about this (naturally elusive) concept, but take a look at the latest data from the inflation swap market (we’ll do an explainer on this; for now, just look at how expectations have rebounded already from their low at the end of last year; if you want technicalities on this market, try the beginning of this document). If you prefer to focus on the implied inflation expectation in indexed 10 year US Treasury bonds this stood at 1.4 percent on Friday and shows a similar rebound over the past few months. (For some reason, my official colleagues prefer bonds; my financial market friends prefer swaps.)

As we explained in our Washington Post article yesterday, we strongly support what Ben Bernanke is doing - there is a lot of uncertainty and the alternatives are much worse. But we don’t accept the premise that the Fed’s actions today cannot cause inflation quite soon. Arguing more about this, here and elsewhere, should help us think about how to manage the consequences and minimize the costs.

Excessive inflation is a typical outcome in oligarchic situations when a weak (or pliant) government is unable to force the most powerful to take their losses - high inflation is, in many ways, an inefficient and regressive tax but it’s also often a transfer from poor to rich.

Deflationistas also give short shrift to the notion that in a world where economies are connected to each other through currency markets and other mechanisms, deflationary pressures can easily be exported from one location to another, whether through intentional policy maneuvers or not.

In "Swiss Slide into Deflation Signals the Next Chapter of this Global Crisis," The Telegraph's Ambrose Evans-Pritchard suggests that such a strategy could find a popular and growing appeal, sparking a contagious dash towards currency debasement that leaves some countries holding the inflationary bag.

Watch Switzerland closely. It is tipping into deflation, the first Western country to succumb to Japan's disease.

Swiss consumer prices fell 0.4pc in March (year-on-year). Swiss CPI will be minus 1pc at least by July, nearing the level where spending psychology changes. By the time you have a self-feeding spiral, it is too late.

"This is something that we must prevent at all costs. The current situation is extraordinarily serious," said Philipp Hildebrand, a governor of the Swiss National Bank.

The SNB is not easily spooked. It is the world's benchmark bank, the keeper of the monetary flame. Yet even the SNB's hard men have thrown away the rule book, taking emergency action to force down the exchange rate of the Swiss franc.

Here lies the danger. If other countries try to export deflation by this means, we will face a second phase of the global crisis. Taiwan is already devaluing. Korea, Singapore, and Sweden all seem tempted to follow. Japan is chomping at the bit.

"We don't fully realise in the West what a catastrophic collapse Japan has suffered," says Albert Edwards, global strategist at Société Générale. "The West has dumped a large part of its economic downturn onto Japan by devaluing against the yen."

This is about to go into reverse as Tokyo hits the ping-pong ball back across the net. "As the unfolding collapse in the yen gathers pace, the West will see its green shoots incinerated to dust," he said.

Japan's industrial output fell 38pc in February (year-on-year), mostly concentrated into the last four months. No major economy imploded at this speed in the 1930s. The country has been hit by a double shock. As an export power it has taken the brunt of Anglo-Saxon belt-tightening: as the world's top creditor it is cursed by a "safe-haven" currency that soars in moments of danger – largely because the Japanese bring home their wealth till the storm passes. Normally, Japan can cope. This time, the yen's rise has pushed the economy over a cliff.

The yen must come back down to earth, and soon, or Japanese society will start to disintegrate. If necessary, the Bank of Japan will force it down by intervention, as occurred in 2003-2004.

Will China stand idly by as Japanese unleashes a shock to the global system through competitive devaluation? That depends whether you think China's spring recovery is the real thing, or an inventory build-up before the next downward slide. The Communist Party says 20m jobs have been lost since the bubble burst. This cannot be tolerated for long.

It is remarkable that China's fall into deflation has attracted so little notice. China's CPI was minus 1.6pc in February. The country has built too many factories producing goods that the world cannot absorb. The temptation is to shunt this excess capacity abroad. A faction of the politburo is already itching to devalue the yuan.

Of course, Britain has already played the currency card. That is different. The pound's fall, though welcome, is a side-effect of the Bank of England efforts to stem the credit crunch. There has been no currency intervention.

Crucially, Britain has a current account deficit. Many countries toying with devaluation are exporters with surpluses – 15.4pc of GDP for Singapore, 8.4pc for Switzerland, and 6.1pc for China. If these countries refuse to let their imbalances correct, world demand must implode.

Mr Hildebrand denies that the SNB is pursuing a "beggar-thy-neighbour' strategy. Like the yen, the franc suffers from the safe-haven curse: everybody buys it in a storm. This tightens monetary conditions. The SNB cannot easily offset this. It has already cut interest rates to near zero. There are not enough Swiss government bonds in the market to rely on the sort of "QE" asset purchases being carried out by the Bank.

Ultimately, I suspect this crisis may mark the moment when the Swiss franc loses its safe-haven role. Credit default swaps (CDS) measuring risk on five-year government debt have reached 127 for Switzerland, higher than Britain at 118. Norway has the world's lowest CDS at 48, reflecting its status as a petro-democracy.

Switzerland's banks are over-leveraged. Loans to emerging markets equal 50pc of GDP (half to Eastern Europe). Banking secrecy is dying. Fortunately for the Swiss, they have built up $700bn in net foreign assets for a rainy day. Improvident Britons are less lucky. But that is another story. What we risk now is a game of deflation "pass-the-parcel" worldwide. The economic establishment was caught off guard from 2003 to 2007 because it overlooked the way that Asia's unbalanced relationship with the West was feeding a credit bubble.

It may be caught again as the same warped structure leads to a chain of (panicked) devaluations.

Enjoy the "bear-trap" rally on global bourses this spring. But remember, we have only just begun to see the mass lay-offs and hardship caused by this slump. The politicians will act to save their skins. Markets may not like the result.

Comments

[Vijay]

Great post Michael! Peter Schiff talks about these concerns at length in his talk at the Austrian Scholar's Conference:

http://www.youtube.com/watch?v=EgMclXX5msc

[Brad Surly]

Americans and Westerners generally can't conceive of a confidence crisis in the almighty dollar. But it is coming, and that right soon.

[Jr Accountant]

Ruh oh, guess this means we're in trouble??

This deflation line is a joke - the scariest part of all of it? Bernanke and Co. BELIEVE it. They've been lying so long they don't even know the truth anymore - or scarier yet, they actually believe this stuff.

[Independent Accountant]

I can't make a credible case for deflation. Junior may be correct, ZimBen may believe the deflation case. On the other hand, he may be knowingly defrauding the American public.

[DocG]

First, Michael, I want to congratulate you on getting it right. And thanks for reprinting the interview, in your latest post, that makes it clear you saw what was coming while others were in denial. Thanks also for the excellent post on inflation, which makes some important points.

As I see it, however, the real problem is not so much whether we fall down into deflation or up into inflation, but the more fundamental problem that the world economy no longer has any direction at all. What's happening now is neither deflation nor inflation but a panicky series of lurches from one to the other. As I wrote recently on my own blog,

"Rational decisions regarding money can no longer be made by either businessmen or government officials. Bankers and traders can certainly continue to game the system. It's still possible to make money, lots of it. Also to lose it. But when it comes to things like the pricing of consumer goods, deciding how much tuition to charge, making certain industries cost-effective, determining tax rates, and, above all, deciding how much money can safely be pumped into failing financial institutions, auto companies, stimulus packages, etc., without destroying the economy, we have reached a unique point in history: we no longer understand where we are going or why.

Charge more for your product and you lose your customers, charge less, or the same amount, and you can't pay your debts. Why pour money into a failing auto industry if no one can afford to buy the products? Why allow that auto industry to fail if failure will lead to huge job losses in every corner of the country? Etc."

In short, we'd be better off if it were simply a matter of having to accept either deflation or inflation. However, the financial meltdown you so astutely predicted has taken us beyond that point.
http://amoleintheground.blogspot.com/