Steve Saville on US "Deflation".
- 17 July, 2002
Erring on the side of inflation
The consensus view at the moment is that excessive monetary stimulus can easily be taken back later therefore the Fed should
facilitate the creation of too much money now rather than risk creating too little money. The concern is that if too little money is created
then the US will follow the path taken by Japan during the 1990s and experience a decade-long economic slump. The following
extract from a report by Deutsche Bank AG Foreign Exchange Research Department reflects this popular thinking:
"As a recent Federal Reserve staff study... concluded , when "the risk of deflation is high, (monetary) stimulus should go beyond the
levels conventionally implied by baseline forecasts of future inflation and economic activity." While excessive monetary stimulus could
always be taken back at a later date if required, if too little stimulus is provided and the economy slips into outright deflation, then it
might become quite difficult - both presently and in the future - to pull the economy out of a persistent slump, as the Bank of Japan
has experienced in the past decade."
So the biggest risk, apparently, is that the US is about to follow in Japan's footsteps and the best way to mitigate this risk is,
apparently, massive monetary stimulation. In our opinion the current consensus view incorrectly defines both the problem and the
solution to the problem. Here's why.
Firstly, if the current consensus view was correct then no economy would ever go through a prolonged period where inflation was a
major problem. The central bank could always err by creating excessive monetary stimulus and then, as soon as the inflation started to
cause trouble (higher consumer prices and higher long-term interest rates), simply bump-up short-term interest rates a couple of
notches and cut the inflation problem off at the knees. Unfortunately, history teaches us that it is not that simple.
Secondly, the differences between the situation in the US today and the situation in Japan during the early-1990s are huge and
these differences all but guarantee a different outcome. For example, whereas Japan had a strong currency, a current account
surplus and a very low money supply growth rate during the first half of the 1990s the US presently has a weak currency, a large
current account deficit and a high money supply growth rate. To use a medical analogy, the medicine currently being prescribed for
the US is designed to cure the disease that afflicted 1990s' Japan. The US patient, however, is suffering from a different disease and
the remedy that might have eased the pain 10 years ago in Japan is not going to work today in the US. In fact, it would probably
make things worse because one of the major problems currently facing the US isn't a scarcity of dollars, it is a glut of dollars. There are
way too many dollars in the world and yet the proposed cure is to create more dollars.
Thirdly, the current US predicament is a consequence of excessive monetary stimulus (although the problem was never correctly
diagnosed by the Fed or by the mainstream news media). How could more of what caused the problem possibly be the solution to the
problem?
Erring on the side of inflation is a risky policy at the best of times, but here we have excessive monetary stimulus being strongly
advocated for a country that already has an inflation problem. Over the past several years the US has experienced the invisible kind
of inflation (the kind that results in higher asset prices while consumer prices remain quiescent), but there are signs that the inflation
has begun to evolve into the visible kind (the kind that results in higher commodity and consumer prices). When the currency is
perceived to be losing its purchasing power at an accelerating pace an inflation mentality sets in. Lenders begin to push interest rates
higher in anticipation of the accelerated currency depreciation and buyers begin to hoard (companies build-up their inventories and
consumers bring-forward their purchases because prices are expected to be higher in the future). The hoarding, in turn, leads to still
higher prices and higher interest rates. Once an inflation mentality has been established it has, in the past, taken very aggressive
tightening by the central bank - aggressive enough to thrust the economy into a severe recession - to eradicate it.
The root of the problem presently faced by the US is that it is not possible to smoothly transition from an economic boom fueled by a
massive credit bubble to the next period of sustained economic growth. The excesses of the credit bubble must first be worked off and
this is necessarily a very painful process. However, regardless of the fact that a smooth transition is impossible the main reason we
continue to forecast a growing US inflation problem over at least the next 12 months is that a smooth transition will continue to be
sought by the US Government and monetary authorities. |
