Warning: Declaration of action_plugin_safefnrecode::register(Doku_Event_Handler &$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/safefnrecode/action.php on line 14

Warning: Declaration of action_plugin_blog::register(&$contr) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/blog/action.php on line 0

Warning: Declaration of action_plugin_blockquote::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/blockquote/action.php on line 0

Warning: Declaration of action_plugin_include::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/include/action.php on line 0

Warning: Declaration of action_plugin_popularity::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/popularity/action.php on line 0

Warning: Declaration of action_plugin_redirect::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/redirect/action.php on line 0

Warning: Declaration of action_plugin_captcha::register(&$controller) should be compatible with DokuWiki_Action_Plugin::register($controller) in /home/public/dw/lib/plugins/captcha/action.php on line 0

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: Declaration of Doku_Renderer_metadata::table_open($maxcols = NULL, $numrows = NULL) should be compatible with Doku_Renderer::table_open($maxcols = NULL, $numrows = NULL, $pos = NULL) in /home/public/dw/inc/parser/metadata.php on line 24

Warning: Declaration of Doku_Renderer_metadata::table_close() should be compatible with Doku_Renderer::table_close($pos = NULL) in /home/public/dw/inc/parser/metadata.php on line 24
Upping the priority of inflation protection [ClearOnMoney]
Top

Site

About
Contact

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656
Sitemap

Profile

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656
Trace:
Upping the priority of inflation protection

Reference

Main
Updates
Schedule

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656

Warning: preg_replace(): The /e modifier is no longer supported, use preg_replace_callback instead in /home/public/dw/inc/auth.php on line 656
Commentary

Upping the priority of inflation protection

18 Sep 2012 by Jim Fickett.

The main inflation danger for the US always has been, and always will be, with Congress. But the new Fed policy makes it easier for Congress to avoid responsible behavior, and harder for the Fed to remain independent in the future. In turn, this makes it more likely that dealing with unsustainable deficits will be postponed until balancing the budget is no longer possible, and the only way out is high inflation or outright default.

I am going to increase the priority of buying assets that provide protection from US inflation. This post explains why.

Focus on medium term risk, without trying to predict a timetable

Those who laugh off the possibility of serious inflation like to set up a straw man caricature of the danger, which they can easily knock down. The straw man is that the Fed is printing money like mad, and that this new money will immediately lead to hyperinflation. So let me say at the outset that I fully understand the money currently being created by the Fed is sequestered as excess bank reserves – not in circulation and not currently raising prices. I am also well aware that there is little sign of inflation in current statistics; the danger is probably, though by no means certainly, still years off.

Inflation is a complex phenomenon. Historically, high inflation typically follows an increase of money in circulation due to high government deficits (there are many examples in Bernholz' classic book; see especially chapter 4). But real supply and demand, as well as mass psychology, also play a role. It is thus very hard to predict a particular outcome, and especially a particular timing. Rather, one should take the danger seriously, and set up one's portfolio with the danger in mind.

The main danger is in Congress, but the Fed is aiding and abetting

Deficits and money printing come about because those who hold the purse strings always promise more than they can deliver. So the core danger lies in Congress which, unfortunately, seems as unlikely as ever to get the long-term budget, including unfunded liabilities like medicare, under control. None of this has changed recently, and I've written about the problems in Congress before (The long-term inflation danger has risen). What has just changed is Fed policy, and in a way that synergizes unhappily well with the weakness of Congress. So the focus here is on Fed policy.

The Fed's latest policy, here referred to as QE-infinity, is to buy long-term securities in order to keep long-term interest rates low until “the outlook for the labor market [improves] substantially”.

What is most shocking about this policy is its arrogant recklessness. Mainstream economists admit that with the current extremes in monetary policy we are experimenting in real time with the world economy, with no confidence in what the outcome will be. William White, formerly Economic Advisor and Head of the Monetary and Economic Department with the Bank for International Settlements and now chair of the Economic Development and Review Committee with the OECD, wrote in Ultra Easy Monetary Policy and the Law of Unintended Consequences,

The central banks of the advanced market economies (AME's) have embarked upon one of the greatest economic experiments of all time – ultra easy monetary policy. …

From a Keynesian perspective … it seemed clearly appropriate to try to support the level of spending. …

There is, however, an alternative perspective that focuses on how such policies can also lead to unintended consequences over longer time periods. … costly misallocation of real resources … that would end in crisis. … boom-bust processes that might threaten both price stability and financial stability. …

It is also argued in Section C that, over time, easy monetary policies threaten the health of financial institutions and the functioning of financial markets … this provides another negative feedback loop to threaten growth. Further, such policies threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments. Further, once on such a path, “exit” becomes extremely difficult. Finally, easy monetary policy also has distributional effects, favoring debtors over creditors and the senior management of of banks in particular.

I am particularly concerned about “such policies threaten the 'independence' of central banks, and can encourage imprudent behavior on the part of governments” and how this increases the danger of inflation. The main reason the danger has increased is that the Fed has promised to continue QE until the employment outlook improves substantially; however there is no guarantee that their actions will have any significant effect on employment. Most economists, whether they support the policy or not, have very little confidence that there will be a strong effect. For example, James Hamilton at Econbrowser (who supports the policy) says,

The Fed can and will keep U.S. inflation from falling much below 2%, and that may help a little. Investors should expect that, and not a whole lot more.

And Jeffrey Lacker, head of the Richmond Fed, who voted against the new policy, wrote about his dissent,

improvement in labor market conditions appears to have been held back by real impediments that are beyond the capacity of monetary policy to offset. In such circumstances, further monetary stimulus runs the risk of raising inflation

So the Fed's main goal could easily continue to recede like the end of the rainbow, in which case they may push on, giving too little weight to any unintended consequences, for far too long.

For the role of Congress in creating inflation, the issue is that keeping rates low postpones market discipline. As long as the Fed succeeds in keeping rates low, Congress will postpone dealing with the deficit. It is naive in the extreme for Bernanke to continue saying to Congress, “this is just a temporary expedient; you have to really fix the problem”. Congress will not act until there is an emergency. And it is much better to have an emergency now, when a recession will result from higher rates, than in the future, when, as with Japan, debt will be so high that higher interest rates will leave only two choices – high inflation or outright default (see also Two reasons to stay worried about inflation).

For the role of an independent central bank in preventing inflation, the issue is that the more dependent the nation gets on low interest rates, the harder it is for the Fed to countenance a rate rise (not to mention the loss of face entailed in causing enormous losses on its own balance sheet).

James Hamilton voiced a similar concern when the Fed first began a series of unprecedented actions in 2009:

One of my concerns is that the Fed's new balance sheet has compromised the independence of the central bank …

The reason I find that loss of Fed independence to be a source of alarm is the observation that every hyperinflation in history has had two ingredients. The first is a fiscal debt for which there was no politically feasible ability to pay with tax increases or spending cuts. The second is a central bank that was drawn into the task of creating money as the only way to meet the obligations that the fiscal authority could not. Every historical hyperinflation has ended when the fiscal problems got resolved and independence of the central bank was restored.

The context has changed, but that concern remains valid.

One realistic scenario

I'll offer one realistic scenario of how things could get out of control. This is not a prediction; it is offered only to illustrate that the above worries are not purely abstract.

The big banks are even bigger now than they were before, and the fact that none of the perpetrators of the last crisis has gone to jail means that the culture at the banks is unchanged. Dodd-Frank is overall a positive thing, but it has been extensively watered down and, in particular, it is not at all clear that large, international banks that are “too big to fail” can really be taken into receivership and wound down in an orderly manner. So, as the easy money policy encourages more risk taking, it is more than likely that we will have another financial crisis, and that the government will once again have to step in with extraordinary measures. The difference this time is that the federal debt is already at a point that many international observers consider dangerously high. So it would not be very surprising if a large government rescue caused an international flight from dollars and an increase in Treasury rates. The Fed would now be in an impossible situation. To allow rates to rise would be an admission of defeat. But with buying required on a much larger scale, it is not at all clear that the Fed could, as now, buy the bonds in a way that kept the newly-created dollars out of circulation.

Consequences for investing

Although I think high inflation is very likely, I prefer not to bet directly on my predictions about the future. So my goal is to have a portfolio of investments that make sense in any case, but to give some priority to investments that provide inflation protection.

My current portfolio priorities are (1) buy long-term, solid investments that are mainly a way to preserve capital, (2) buy bargains, (3) be prepared for a (very likely) fall in the (highly overvalued) US market, by not owning things that are overvalued, (4) prepare for inflation. These priorities are not changing greatly. Rather I am increasing the importance of point 4. What this means is that I will decrease my cash position (losing some flexibility for taking advantage of opportunities in the next recession), and be willing to sometimes buy things that are reasonably valued, rather than only things that are bargain priced.

In addition to the increasing danger of high inflation, there is also the consideration that Fed policy is pushing up asset prices, making it ever more difficult to find investments that truly make sense from a value perspective. So, always torn between the desire to take advantage of opportunities before they disappear, and the desire to wait for better opportunities, I will do a little more of the former and a little less of the latter.

A footnote on hyperinflation

The word hyperinflation is often tossed around rather carelessly. But a true hyperinflation, where the total value of all currency in circulation goes essentially to zero, is very different from a merely high inflation. A hyperinflation is so disruptive that normal investing goes out the window, and one must concentrate on survival. So one should treat the concept with respect, and neither completely ignore the possibility, nor act as if the risk is close if it is, in reality, remote.

Bernholz says (Bernholz, Monetary Regimes and Inflation, 5), that budget deficits over 25% of GDP are closely linked to hyperinflations. Is such a deficit even imaginable for the US, where current deficits (even including off-budget items) are less than 10%?

Yes. There was an interesting study out of the Bank for International Settlements two years ago, entitled The Future of Public Debt: Prospects and Implications. In it Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli consider the realistic course of government debt in the scenario where non-age-related spending remains steady, and unfunded liabilities for an aging population are properly accounted for. They find that

Unless the stance of fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit-to-GDP ratio will rise to … 8–10% in Japan, Spain, the United Kingdom and the United States …

But the main point of this exercise is the impact that this will have on debt. The results plotted as the red line in Graph 4 show that in the baseline scenario, debt-to-GDP ratios rise rapidly in the next decade, exceeding … 150% in Belgium, France, Ireland, Greece, Italy and the United States.

Here is the graph:

Note that in this projection it actually takes only a few years for US debt to exceed 150% of GDP. If one imagines a 10% interest rate – not at all impossible – and adds the resulting 15% of GDP to the 8-10% primary deficit already mentioned, the result is in the range that could lead to a hyperinflation.

So we are not close, but it is also not that hard to imagine conditions leading to a hyperinflation.