Inflation Remains The Least Bad Option For The US
Marshall Auerback
Benjamin Bernanke has clearly learned a thing or two since his now notorious celebration of the Fed’s electronic printing press: never frighten the foreigners who hold much of your debt by abandoning the guise of being vigilant about inflation. A crashing dollar means significantly higher rates, which are something the US economy can ill-afford at this juncture. According to Bernanke, the Federal Reserve should be able to push short-term interest rates up at a gradual pace, the speed of which to be dictated by economic events not, one presumes, market speculators. This is a polite way of trying to tell those baying for a sharp increase in rates in order to get the central bank “ahead of the curve” to get stuffed. To us, it confirms the suspicion that the Fed has no intention of embracing anything but the most cosmetic forms of tightening, given that the real goal is to deliberately engineer as much inflation as possible on the quiet. On the quiet it must indeed be, because any explicit promise to the contrary could turn today’s gentle dollar decline into a rout, thereby fuelling precisely the kinds of anxiety in the bond market that would drive yields much higher.
For all of the talk of “rising inflationary pressures”, the real story of the 21stcentury thus far has been the vast explosion of debt on the heels of a historically unprecedented credit bubble. The household sector never quite made it back to a net nominal saving or financial surplus (or free cash flow, if you prefer) position either during the official recession of 2002 or during the more recent double dip of 2003. There is no precedent for such profligate behavior by U.S. households. In all prior recessions households paid down debt and home price inflation abated. It is hard to think of any other economy where highly indebted households have responded to the threat of severe asset deflation by going on an even greater debt financed spending spree. But somehow, now that it has happened, financial market participants have come to regard it as normal and sustainable behavior.
Part of this complacency has undoubtedly been fostered by members of the Federal Reserve itself. To quote Mr. Bernanke again: “2003 seems to have marked the turning point for the US economy, and we have reason to believe that 2004 will see even more growth and continued progress in reducing unemployment.” The March Payroll Employment report seemed to support Bernanke’s optimism, both statistically and in terms of the outlook for the economy and markets. It strongly suggested that firms have shifted toward hiring more workers as opposed to relying on longer hours and further investment as the low-cost way to increase output. If employment increases remain at about 175,000 per month (the three-month average through March was 171,000), the economy will approach a more normal picture with about 1 percentage point of growth coming from higher employment and 2.5 to 3 percentage points of growth coming from higher productivity.
Add to the pickup in employment growth a surge in U.S. retail sales signaling stronger consumption, and you have a rapid shift from a U.S. supply-driven growth pattern to a more typical demand-driven growth picture. Those of us who have questioned the sustainability of US consumption appear to have been wrong-footed again.
On the other hand, this “normalized” economic recovery has not been without some cost: The benign, faster growth with lower inflation during the second half of 2003 (a dream for the Fed, if not for the Bush administration) has become a slower growth, higher inflation pattern. Higher inflation was the clear message in the March Consumer Price Index (CPI) report. Core CPI inflation (excluding food and surging energy prices) rose 0.4 percent, pushing the first quarter annual inflation rate to almost 3 percent.
Add to this a huge new “tax” in the form of $40 oil, and it is clear that the USconsumer will face challenges ahead. And for those who thought that the Saudi’s would ride to the rescue, Monday’s response to their’ “pledge” to increase production should put paid to any lingering belief that $40 oil is but a temporary aberration. The Saudis were the only OPEC member to come out of the Amsterdam meeting with planned production hikes. If nothing else, this isolated position will earn them the ire of terrorists wishing to disrupt oil production and thereby make the House of Saud’s position even less tenable politically.
For several quarters, falling US interest rates have enabled a credit boom to continue unabated. This has masked an increasingly ominous trend in debt service burdens as a percentage of total income. By the end of 2003, UShousehold debt service payments accounted for 13.1 per cent of disposable income, close to the record high of 13.3 per cent recorded in 2001, and considerably higher than the mid-1993 level of 11 per cent. This figure is almost certainly at record highs today, given the recent rise in rates and the corresponding increase in mortgage payments for those who cleverly followed Alan Greenspan’s exhortations to embrace adjustable rate mortgages.
It is assumed that increases in credit stimulate aggregate demand. In the short run that is always true. But in the long run it need not be true. The expansion of credit is an increase in debt. When debt levels are low a credit expansion which increases debt does not leave a legacy which later suffocates demand, since the resulting still low level of debt is not yet a problem. But when debt levels are very high the increases in debt created by credit expansion soon act as a burden on demand. Undoubtedly, the Fed is keenly aware of this problem; hence, the persistent reluctance to deal with the forces of speculation now so prevalent in today’s turbo-charged financial system.
It follows from the above that, as the level of debt relative to income rises, it should take larger expansions of credit to achieve any given percentage increase in demand, since the now high and climbing debt burden acts as a countervailing force to depress demand.
In spite of this extraordinary growth of leverage in the US economy, financial and business intermediaries continue to fret about renewed inflationary pressures and a corresponding rise in interest rates. We too worry about the rise in interest rates, as it could very well create the conditions in which the current credit boom turns rapidly to bust, creating a huge economic disaster in its wake. We suspect that the Fed is aware of this danger as well, which is why we continue to believe that its supposed “anti-inflationary vigilance” is simply a ruse designed to placate foreign creditors, who might otherwise up and run if they genuinely understood that the most likely course of action to be embraced on the quiet by the Fed is a policy of debt confiscating inflation.
Unlike a creditor nation with high household savings, such as Japan, it is difficult for the Federal Reserve to announce a deliberate policy of inflation, precisely because it might very well spook the country’s legion of foreign creditors and create the conditions for huge capital flight. This in turn would create the risk of a runaway dollar devaluation, which would likely have the ultimate impact of driving long term rates much higher, thereby undercutting the Fed’s persistent efforts to ease. So it behooves Mr. Bernanke to celebrate the recent impact of rising long term rates, in effect validating this rise by suggesting that “asignificant portion of the financial adjustment associated with the tightening cycle may already be behind us,”, thereby minimizing the need for further substantial action on the part of the Fed. Which means, of course, less chance for real tightening, a greater likelihood of higher inflation, the unstated policy objective.
As the experience of the late 1970s demonstrates, inflation is nothing to be celebrated. But it is clearly the lesser of two evils, if we are to compare the social costs incurred during that period with those experienced in the Great Depression, analyzed in great depth by Irving Fisher. In his pioneering works of the 1930s, Fisher described how, in response to excess debt, borrowers try to liquidate assets and pare expenditures and lenders try to call in loans. This process sets in motion a negative feedback loop whereby efforts to reduce debt depress the cash flows that would normally service that debt, consequently generating outright price deflation which increases the real size of debt and debt repayments. This dynamic is recursive, propagating ever more economic deterioration and even greater pressures to reduce debt which, paradoxically, increases it in real terms.
To avoid this dilemma, there must be enough accompanying inflation to generate negative real interest rates and thereby erode the crushing real burden of that debt. This can only be achieved through the deliberate creation of inflation, given the presence already of zero per cent nominal interest rates.
How high is an appropriate inflation level for the US? Well, following the first oil price shock, consumer price inflation rose to 25 per cent in Japan, but was eradicated within 18 months. But the longer-term effect of such high levels of inflation was a substantial erosion in the prevailing high real cost of debt, thereby setting the stage for a dramatic recovery the following decade (during which, new policy errors were made unrelated to the inflation of the 1970s).
Of course, there is nothing to compare with the extraordinary financial Leviathan that the Fed has created today in contrast to previous economic cycles, and so the Japanese analogy can only take us so far. In addition, the embrace of inflation should ideally come after the economy has experienced some degree of adjustment and corresponding balance sheet repair. But, in fact, what has happened is that a Fed and administration, hell bent on preventing a full unwinding of the 1990’s Bubble and its consequences, fostered expansion in a credit/debt bubble to keep the economy and markets aloft, which does call into question whether a simple embrace of yet higher inflation will actually achieve the desired policy outcome of destroying this debt. In effect, the best for which the Fed can hope is that more monetary accommodation – the very source of today’s acute problems – will somehow work to alleviate the worst of the debt disease. Hardly a comforting thought for holders of US assets.
Economic theory tells us that massive monetary base growth should lift aggregate demand and reverse debt deflation dynamics. So does history: the largest increase in the U.S. monetary base in its history coincided with the reversal of the U.S. economy at the bottom of the Great Depression after price deflation had driven the private debt/income ratio to a record high. But, in today’s complex globalized financial system, so one really knows how to engineer a helicopter drop of base money. Some extreme policy action will be taken, but it is too early to say what it will be and whether it will prove effective.
The efforts of U.S. policy makers to avoid a full unwinding of the 1990’s stock market bubble through the encouragement of a credit bubble and a housing bubble has, despite something of a recovery, made both conditions worse, so there is no guarantee that an embrace of inflation, even if on the quiet, will achieve anything better than a 1970s style stagflationary outcome. Such is the state of the US economy today, that this is perhaps the least bad outcome on offer in terms of policy prescription, a true testament to the Federal Reserve’s grotesque abdication of monetary responsibility under the tenure of Alan Greenspan. It is shocking to think that this man has been appointed for another term, but perhaps poetically just that he will likely still be in office when forced to face the full consequences of his earlier implemented economic follies.
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