Does Inflation Really Mean Recovery?

The Fed clearly is not letting up on its battle against “deflation”, we continually witness the call for further monies to be spent, with congress approving of it. If you are a Keynesian economist this is the right thing to do. Many Keynesians believe the Japanese economic collapse in the early 90s could have been avoided if the government had intervened earlier on in stimulating the economy. The first question however is whether this is really a battle against deflation. The current bust cycle in the economy is viewed as necessary in wiping out all excesses that may have arisen during the economic boom. So rather than calling this deflation, is this just a situation were prices across board are resetting to more appropriate levels or is this the meaning of deflation?

Do we really believe the economy can continually grow for years at a steady rate without a painful correction? Yes, in theory this is possible, but like economics teaches us, human behavior cannot be predicted, hence there will always be excesses, the party will always get wild once there’s liquor and no cops around, and the recession or bust is supposed to end the party, and clean up the mess in the system. In addition, the beauty about an economic bubble bursting is that ideally, it provides an opportunity for wealth to be spread across broad, people who have been conservative now have an opportunity to make carefully analyzed investments that are currently at bargain prices. In times like this cash is king, for anyone who has been prudent enough to save cash, or anyone who has access to low cost funds, these monies will be handy in a time like this.

Given this exciting fact, where are the opportunities then? We are witnessing a situation in which there’s more of a social system in place, and cash injections are going to big corporations that have been irresponsible in their behavior (we all know this and I wont rant on this). If in a capitalist environment, the consumer is the key driver; won’t it make more sense to have a bigger bailout for the consumer? If more money was put in the pockets of the American tax payer, this money will ultimately be spent and there will be somewhat of a recovery in the system. The Fed’s balance sheet in the course of this economic crisis has grown by $1.2 trillion, which is approximately $4000 for every American. Compared with a $500 dollar check, that’s more likely to be stimulating.

Now with the measures being employed by the Fed to combat this “deflationary cycle”, 0% interest rate, stimulus checks, absorbing bad debt, all done by money printing, the expected result is to have a bounce back in the economy. But when does the Fed know when to stop? Is it when we begin to see CPI come in at 0.5% over a couple of quarters, what economic indicators will tell the Fed that they can take their feet of the economic gas pedal? At any point the Fed get’s to this discovery, they most likely would have shot too far in stabilizing the economy. So will inflation in the system say to us that the Fed has done a good job?

From the current look of things the market is pricing in a long deflationary period, this is evident from the spread between the 10 Year Treasury bond and the 10 Year Treasury Inflation Protected bond. The current spread is approximately zero, which signifies the bond market believes that over the period of 10 Years, the inflationary concerns of the economy is priced in, and this is very misleading. Except one believes that just enough money that’s needed to restore the economy will be printed, inflation is definitely going to rise. In which case there will be a new economic crisis to deal with, so then again, does inflation really symbolize a recovery in the economy?

The Rise of the Beast: Inflation

Last week, the Fed took a very dramatic step in providing some relief to the ailing economy, by creating money to buy bad assets of the crumbling financial institutions. Last week the Fed bought $5 billion of Freddie Mac, Fannie Mae, and Federal Home Loan Bank corporate debt.

Okay we know the Fed had been printing money, but prior to this, the Fed swapped out bad assets with treasury bonds, which is not an impressive move either. A better way to think about the new scheme is that the Fed magically increased account balances by a couple of billion dollars. You may pause to think why; could the situation be that bad that it calls for a panic? Well the idea was that by doing this, they can create credit that will be loaned out for people to re-finance. How’s that different from all the other credit injection schemes? The difference is this, the old scheme acted as a pawn shop to the financial institutions (well, almost like considering the assets the financial institution owned were worthless), and with this new scheme the Fed is “giving it out”. Now which cash infusion are you likely to spend thoughtlessly, the “free money” or the pawn shop cash? Exactly what I thought, the free money!

So what’s the point here? $50 billion may be a small number giving the size of the Fed, but like everything else that comes from the Fed, it’s a teaser, what happens when that figure is multiplied by 10? Being free money, it is loaned out freely, and economics teaches us that when money becomes cheaply available, everyone wants more for stuff, and then inflation kicks in. The blinding battle now is the battle against deflation, oil prices have crumbled to about a third of its highs last year, CPI numbers show YoY decline, highest level of joblessness seen in years, the Fed is using all its guns to fight “deflation”, but like every monetary policy that comes from the Fed, there is always the issue of latency.

This week we should see the outcome of the last FOMC meeting for the year, and the market expects a 50 basis point cut. Short term treasury yields are sitting at close to zero. Hence, another tool that may be used by the Fed to fight this battle on deflation is by debasing the dollar. By increasing the availability of US dollars, making it very cheap, the US can cause buyers within its market (we saw a little bit of this last year with Europeans flying into the US to shop). So why is this a suspect now, firstly it has been done before, secondly given the recent actions of the government it wont be above them to do so, thirdly the US dollar has been falling steadily for about two weeks now. Bernanke has clearly stated that he will do everything to fight deflation.

Many analyst proclaim that the condition will get much worse, and some make the case that there is the likelihood of some 1930s kind of incident, I don’t have a crystal ball, but I like to be optimistic, so I say that things are going to take a reverse course, and begin to get better in about 6 months, for a more technical view see here, and in this recovery process we just may witness the Fed fighting a new beast next year, well maybe in 2 years.

Lest I forget, the total amount of Federal Reserve bank monetary base has increased twofold in three months, see http://research.stlouisfed.org/publications/usfd/page3.pdf, that’s what you call a printing press!