Diary of a Financier

The Fed’s Fight with Inflation & Deflation

In Economics on Fri 4 Mar 2011 at 10:42
  • A key tenet to my outlook is the expectation of low interest rates through 2012’s ARM reset, but commodity inflation could coax Fed action toward the contrary.
  • The consumer will just have the bear the burden of high food & energy costs, but the Fed won’t react unless an increase in bank lending stifles Core CPI, threatening hyperinflation.
  • Consensus will recognize the next 6 months as a stagflationary environment.
  • As we near the June expiry of QE2, DXY will have softly approached 74 (and likely 71) thanks to a stronger EUR, but it will rally from there, along with JPY weakness.
  • At this point, the Fed must keep its foot on the gas–using its portfolio interest & maturity proceeds–to provide monetary support throughout fiscal consolidation, then apply fiercely countercyclical force when the economic upswing persists.

In the wake of Wednesday’s entry about my secular economic outlook, I thought I’d discuss some near-term challenges to my timeline.  In the end, I’m on the lookout for confirmation of a null hypothesis.  In other words, once I’ve formulated an opinion, I look for evidence of the contrary to help me identify the risk or the breakdown of my convictions.  Commodity inflation could dramatically change the trajectory of my outlook.  Since it’s all the rage with Oil (CL/1) back over $100 and an Agricultural boom (food shortage) en force, I’ll start there.

Many have criticized the Fed for focusing on Core, as opposed to Headline, CPI in their measure of inflation.  Commodity inflation is undoubtedly hurting the consumer.  Remember, however, that both Deflation and Inflation are the Scylla and Charybdis of this crisis.  Further, with ZIRP and QE already en force, deflation is the scariest monster.  I opine that  inflation–to a point–might just be another penance for the consumer to bear in retribution for his overleverage.  (It’s compounded by the fact that the government can consciously dole-out such penance, and it hits the bottom 30% of earners & retirees the hardest, while aiding banks.  That’s an unsavory travesty.)

This turns ugly if it persists for too long or if it evolves into hyperinflation, which would require an earnest rally in Core CPI (ex-food & energy).  A spike in bank lending is the most probable catalyst of such hyperinflation.  The Fed has tools to combat such a spike, at least more confidently than they can combat deflation at this point: they’ve tested reverse repos; they can raise the interest rate on excess & required reserve balances; etc.  (Am I too casual in my expectation that the Fed can absorb excess liquidity?  No.  The Fed engineered this recovery when they suped-up banks with the risk-free carry-trade, and they can perpetuate this mechanism or reverse it with the same market intervention.)  However, as we approach that point where the consumer collapses beneath food & energy inflation, how can the Fed control a runaway in these specific inputs without pushing the core inputs into deflation?

Well, the US Dollar (DXY) is resting on a trendline as it approaches a double bottom at 76, the next stops are 74 with a second support at 71:

DXY daily- 1st support @ 74, 2nd support @ 71. Resting on trendline.

The Yen (USDJPY) is also at a similar bottom, which ends at a spread double bottom at $80, which you’ll have to zoom out to 1995 to see:

USDJPY daily- 1st support at 81.12, 2nd at 80.

USDJPY monthly- spread double bottom at 80.

These could be the most important charts in my arsenal right now, because they seem to hold they key to life-after-QE2: the USD has room to slip in the months leading up to QE2’s expiration in June.  The Yen doesn’t look like it’s willing to give any more ground, so in neat coordination with my EURUSD bullish-catapult thesis, a strengthening Euro might drive DXY just that smidge lower.  Upon finding support (my target is 71), DXY should rally through June and the summer.

My guess is that the Fed won’t have to intervene in markets to limit the inflation-driven increase to commodity inputs.  A certain portion of food inflation is coming from shortages–although the Ag boom is a secular investment theme of mine.  A certain portion of energy inflation is coming from social turmoil in MENA states–although oil prices remained stubbornly high throughout 2009-10 (without any contribution from economic demand).  Attributable to these cyclical socioeconomic & geopolitical factors, the lack of a additionally significant catalyst should limit the size and [more importantly] the length of the upside in Ag & Oil, ushering the Fed to the QE2 expiration amid taxpayers bemoaning a stagflationary environment.

That all assumes that the powers-that-be react rationally to the challenges before them (i.e. without panic and with perspective).  Weary of the double-dip, Ben Bernanke is a god-fearing student of the Great Depression, and therefore dovish.  Yet, some Fed governors are dissenting in hawkish opposition.  I’m a vocal critic of our government’s disinflationary approach to economics since the Volker Fed, but since we chose “stimulus” yet again with QE2, it’s my opinion that we must follow-through now, then apply intensely countercyclical force in the upswing of economic vitality.  I agree with Mr. Bernanke that early stimulus withdrawal would be more devastating than the alternative.  (Perhaps I lack adequate perspective since the inflation that exists doesn’t relatively trounce my disposable income. ) From a diary entry of mine a few weeks ago:

I posted a VoxEU research piece in my Bookshelf.  Entitled “A recession to remember: Lessons from the US, 1937-1938,” the column communicates the importance of complementing fiscal consolidation with monetary support for aggregate demand.  Authors Nicholas Crafts & Peter Fearon survey the Great Depression and the government’s missteps, and they arrive at that Bernankian conclusion:

In early 1937, there was still an output gap, estimated by Balke and Gordon (1986) to be around 15% of GNP, but there was a widespread feeling that the depression was over. The focus of policymakers was shifting to concerns about future inflation and a return to a balanced budget. The Federal Reserve was worried by the build up of substantial excess reserves in the banking system while on the fiscal side the ratio of the national debt to GDP had risen from 16% in 1929 to 40% by 1937…

The implication was a discretionary fiscal tightening amounting to over 3% of GDP, according to estimates by Larry Peppers (1973). On the monetary side, a new policy of sterilising gold inflows was adopted in December 1936 and reserve requirements for the banks were doubled in three stages from August 1936 through May 1937… Inflation ceased and prices started to fall again. This was a big reversal and the contraction in economic activity was at similar rates to the early 1930s. The recession ended when reserve requirements were eased, gold sterilisation ceased, and the balanced-budget policy was dropped as government spending was increased by $2 billion…

The key message here for policymaking in the current situation is not that fiscal consolidation should be postponed. Rather, it is that exit strategy needs to focus on providing monetary support for aggregate demand as fiscal stimulus is withdrawn.

This monetary support can be provided rather effortlessly as interest & maturities hit the Fed portfolio from investments in Treasuries/MBS for programs like QE1 & QE2.

–Romeo

Advertisements
  1. […] CRB index (CR/Y) & Precious Metals nicely illustrates the derivation of that formula.  From an entry of mine on March 4: …the USD has room to slip in the months leading up to QE2′s expiration […]

  2. […] the CRB index (CR/Y) and Precious Metals nicely illustrates the derivation of that formula. From an entry of mine on March 4: …the USD has room to slip in the months leading up to QE2′s […]

  3. […] the CRB index (CR/Y) and Precious Metals nicely illustrates the derivation of that formula. From an entry of mine on March […]

  4. […] the CRB index (CR/Y) and Precious Metals nicely illustrates the derivation of that formula. From an entry of mine on March […]

  5. […] the CRB index (CR/Y) and Precious Metals nicely illustrates the derivation of that formula. From an entry of mine on March 4: …the USD has room to slip in the months leading up to QE2′s […]

  6. […] the CRB index (CR/Y) and Precious Metals nicely illustrates the derivation of that formula. From an entry of mine on March […]

  7. […] I agreed with Ben Bernanke that inflation expectations are what matters most.  I’ve asserted that actual inflation wasn’t alarming; rather, inflation expectations contributed to the […]

  8. […] the long-term because of a sensitivity to initial conditions, but my long term US Dollar (DXY) bullishness is also waning, per the monthly chart: DXY […]

  9. […] even attributable to it since CNY revaluation will repair US deficit issues. I’ve been waiting patiently for this turn for some time […]

  10. […] to the monetary accommodation that must accompany such deleveraging, as I’ve repeatedly recommended. A character study of Mr. Bernanke coupled with a close reading of history helped me anticipate […]

  11. […] the CRB index (CR/Y) and Precious Metals nicely illustrates the derivation of that formula. From an entry of mine on March […]

  12. […] expectations: I agreed with Ben Bernanke that inflation expectations are what matters most. I’ve asserted that actual inflation wasn’t alarming; rather, inflation expectations contributed to the […]

  13. […] expectations: I agreed with Ben Bernanke that inflation expectations are what matters most. I’ve asserted that actual inflation wasn’t alarming; rather, inflation expectations contributed to the […]

  14. […] The recession of 1937-38 was really cause by US Treasury’s gold sterilization (September 2011) | Douglas Irwin (VoxEU) The Great Depression’s double-dip is often blamed on premature tightening (fiscal deficit reduction & Fed raising reserve rate requirements), but banks already had excess reserves to meet increased RRRs, so something else was responsible: 1/1934- The US returned to a gold standard by pegging the USD to gold @ $35/oz at a time when gold reserves were 85% of the monetary base; strong gold inflows ensued, expanding US money supply & an economic recovery 12/1936- For fear of inflation, FDR & the Treasury started sterilizing all gold inflows by holding new gold in an idle Treasury account instead of at the Fed, where it otherwise would’ve joined the monetary base; money supply (M2) froze between 1937-38, having grown +12% per annum from 1934-36; the economy tipped into recession in 2q1937 4/1938- The Treasury reversed its policy & began desterilizing gold inflows; the economy recovered in 6/1938 [This is actually a pretty widely held view: Previously] […]

Comment

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s