Two extreme inflation risks for US investors – Mish Talk
Third Quarter Outlook
Please consider the Hoisington Quarterly Review and Outlook for the third quarter of 2020.
Lacy Hunt begins with the conditions central banks must meet to stimulate the economy.
- The Fed must be able to control the monetary base by increasing its liabilities
- The power of the Fed to stimulate economic conditions is a stable relationship between money base and money supply, M2.
- The speed of money (V) should be stable, but not constant. If V is stable, then changes in M2 will control fluctuations in nominal GDP.
- The Fed must have a great deal of leeway to lower the key interest rate in the short term. It has long been recognized that if short-term rates approach the zero limit, monetary capacity will be reduced.
Discussion of monetary base and speed
The Fed can of course increase the monetary base at will.
Regarding speed, Hunt’s statement, “If V is stable, then changes in M2 will control fluctuations in nominal GDP” is correct, by definition.
V = GDP / M2
However, speed does not have a life of its own. It is a result, not a cause. The Fed cannot control the speed now, and it never can.
The speed can increase or decrease with the rise or fall of prices or the rise or fall of GDP.
For discussion, please see If the The speed of money is accelerating Will inflation skyrocket?
Latitude to reduce rates
Point 4 is the key. The Fed has no leeway to lower its rates.
Unlike the ECB, the Fed is even aware of this. They fear lowering rates below the “Effective Lower Bound” ELB
ELB is the point at which further cuts are detrimental in the long run.
- June 4, 2019: Powell ready to cut rates to “effective lower bound” via “conventional” policy
- September 25, 2019: In search of the efficient lower bound
- September 22, 2019: BCE New “as long as it takes” interest rate policy Already huge failure
A Fed study in November 2019 on Lower limit of effective risk confirmed what I had to say in the links above.
In an empirically rich model calibrated to match the main characteristics of the US economy, We find that the tail risk induced by the ELB causes inflation to exceed the target rate by 2% by up to 50 basis points at the risky equilibrium state of the economy. Our model suggests that meeting the inflation target may be more difficult now than before the Great Recession..
I wasn’t aware of the Fed’s ELB study until now. This came when I researched my ELB discussion to add to what Lacy had to say.
Five negative impacts of negative ECB rates
- Negative rates have further weakened the already weak European banking system by charging interest on excess reserves.
- Negative rates have kept zombie businesses alive at the expense of productive businesses.
- Negative rates have destroyed bank profits.
- Negative rates added to unproductive long-term debt.
- The negative rates have increased speculation.
As I have pointed out many times, the Fed slowly recapitalized US banks by paying them interest on excess reserves, the ECB weakened them.
The Fed can see that negative interest rates in Europe and Japan were counterproductive.
So, I highly doubt the Fed will take interest rates below zero. However, the Fed can make other huge policy mistakes.
Only one condition that the Fed can control
Currently, of these four conditions, only the first prevails, and it is the least important of the four. The Fed can control the monetary base by increasing its commitments (bank reserves). The other three conditions, which are much more critical, are no longer present due to the extreme over-indebtedness of the American economy.
Thus, monetary policy ends up with unilateral capabilities, i.e. it can restrict economic activity by reducing reserves and raising rates, but it is not able to stimulate activity. significantly economically.
Indeed, the risk is that the Fed has already exceeded the ELB because this rate is slightly above zero.
It is certainly not less than zero as evidenced by the miserable results achieved by the ECB and the Bank of Japan.
What about inflation risks?
With that question, let’s get back to Lacy once again.
Inflation tail risks
We identify two tail risks for long-term treasury investors: (1) a huge new debt-financed fiscal package and (2) a major shift in the operating mode. The first risk would change the short-term trajectory of the economy. This better growth, although short-lived, could exert transient upward pressure on interest rates as has happened on many occasions. In the longer term, disinflation would prevail and the downward trend in Treasury yields would resume.
The second risk would lead to growing inflationary dynamics, potentially much more substantial. As this discontent escalates, de jure or de facto, the Federal Reserve’s liabilities could become legal tender or a medium of exchange. Already the Fed has taken actions that appear to exceed Federal Reserve Act limits under the Emergency Clause, but so far it is still lending and not directly funding government spending in any meaningful way. But some advocate making the Fed’s liabilities spendable, and a few central banks have already moved in this direction. If the Fed’s commitments became a medium of exchange, the inflation rate would rise and inflation expectations would exceed real inflation. In due course, Gresham’s Law could be triggered when individuals move to hold goods that can be consumed or exchanged for consumer items. This would lead to a massive drop in productivity, so real growth and living standards would drop as inflation escalates.
As long as the federal government’s policy prescription is ever higher debt levels, the path to disinflation will hold and long-term Treasury bonds will be the preferred area of the curve. The continued evolution of economic conditions over the past forty years has necessitated several dramatic changes in our positioning on the yield curve. This flexibility remains constant.
Looking for inflation in the wrong places
These are very important paragraphs from Lacy. They explain why inflation has not picked up as most economists, including the Fed, expected.
There is inflation of course, and huge amounts of it. But the Fed is looking for inflation in the wrong places.
Inflation exists in the asset prices of junk stocks and bonds. Speculation is rampant. Robinhood has turned millions of millennials into day traders who are now convinced that stock prices only keep going up.
Meanwhile, economic bubbles continue to expand and when they do burst we will see a deflationary credit burst that the Fed should fear instead of the CPI deflation that the Fed foolishly fears.
Economic challenge for Keynesians
Of all the widely held but patently false economic beliefs, there is the absurd idea that falling consumer prices are bad for the economy and that something needs to be done about them.
BRI deflation study
BIS did a landmark study and found that routine deflation was not a problem at all.
“Deflation can actually increase production. Falling prices increase real income and wealth. And they can also make the export products more competitiveSaid the BIS study.
For a discussion of the BIS study, please see Historical perspective on CPI deflations: how damaging are they?
Central banks are battling a deflationary boogie man who doesn’t even exist, creating a deflationary debt monster.
The extreme risk is that the Fed will go too far down the rabbit hole in releasing another kind of monster.