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Two reasons to stay worried about inflation [ClearOnMoney]
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Two reasons to stay worried about inflation

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Commentary

Two reasons to stay worried about inflation

30 Apr 2012 by Jim Fickett.

The core reason to stay worried about eventual high inflation in the US is that Congress shows absolutely no sign of genuinely tackling the long-term deficit problem. An additional reason to worry is that, as US debt grows, the Fed will be under increasing pressure not to raise rates.

Philipp Hildebrand, the former chairman of the Swiss National Bank, recently admitted that central bank easing, while safe on the assumption that fiscal policy would be reasonable, could lead to inflation if elected officials fail to rein in deficits:

Governments must create credible and long-term plans for fiscal consolidation. …

Central bankers face an arduous task. During the crisis, they were able to resort to policy measures that resided largely within their own statutory mandates, even if those mandates had to be stretched to breaking point. At some point, central banks will have to unwind their extraordinary policy measures to safeguard price stability. But right now, what needs to be done to land the emergency life raft safely is well beyond the direct authority of central banks. Now is the time for governments, parliaments and bank supervisors to rise to the occasion.

If they fail to do so, the critics who claim that central bankers merely planted the seeds of the next crisis will sadly appear to have been right after all; not because central bank policies during the crisis were inappropriate, but because politicians failed to recognise them for what they were: extraordinary measures to avert the worst case and buy time.

In fact central bankers are not naive, and knew all along that the risk of continuing high deficits was very real. If this turns out badly, the critics will not just “appear” to have been right.

Jeffrey Gundlach, the well-known bond investor, points out that as US debt grows, it gets harder to contemplate higher interest rates, due to the negative effect on government interest costs. This means the Fed will be under enormous pressure not to raise rates when such action is needed to control inflation. (The following quote is from notes made by Joshua Brown of the Reformed Broker at a recent talk by Gundlach.)

The Fed can't raise rates because for every 1% rise it means an additional $150 billion in debt service cost (interest payments to US bondholders). “Why on earth would the Fed ever want to do that?” he mentions that this concept of holding down debt service costs is exactly what Japan has been doing - they are now trapped, they can never raise rates again without committing suicide.

And he makes it very clear that the days of raising rates preemptively to counter potential inflation are over. “THE FED WILL NOT RAISE RATES PREEMPTIVELY. EVER.” See? he notes that there's not been any real inflation since 1985 as the Fed has historically acted preemptively but that was then and this is now.

(Japan's debt is so high that something like a fourth of the government budget is devoted to debt service costs, even with record low rates. If rates were to rise, it would immediately become apparent to everyone that the government budget could never be brought back into balance, and there would be an immediate debt crisis; see Debt service and retirement costs are swallowing Japan's budget.)