Monday, June 12, 2006


Is The Fed Playing A 'No-Win Game'?

Danielle DiMartino looks at inflation and deflation. "Stacy Richardson, a Tulsa reader, recently asked a most intriguing question: Which is the lesser of economic evils, hyperinflation or deflation? You may be wondering, why bother with such musings, if the United States is not at risk of succumbing to either? I'd venture that some of the powers that be in Washington would privately disagree."

"Hyperinflation is defined as inflation run amok, when prices increase unchecked and the currency gets pummeled. The most severe case on record was in post-World War II Hungary when prices doubled every 15 hours."

"Deflation is the opposite. The general direction of prices is downward. The currency, in other words, buys more. That's great if you've got loads of dough. But deflation can be accompanied by falling incomes, which is disastrous if you hold debt. Your payments stay constant while your income falls."

"A quick and dirty survey of the economists I speak with regularly revealed that hyperinflation is overwhelmingly the greater of two evils."

"It comes down to the sovereignty of the United States of America and its claim to the world's reserve currency, a distinction that would be threatened in the event of runaway inflation. If the dollar isn't worth the paper it's printed on, why would any country be inclined to hold dollar assets? By extension, we'd be in a world of pain in the event that hyperinflation took hold because foreign investors hold half our debt."

"The good news is, we're at little to no risk of inflation spiking to untenable levels. In today's globalized world, there are simply too many offsetting disinflationary forces working against inflation. Why then, has every last Federal Reserve official within a microphone's reach sung as hawkish a tune as humanly possible in the last week?"

"After all, as Merrill Lynch chief economist David Rosenberg (he voted hyperinflation) pointed out, the Fed itself took down inflation expectations when it met in May. In March, Fed staffers predicted inflation would be 'slightly higher in 2006.' But by the time May rolled around they were expecting inflation to 'decelerate later this year.'"

"Yes, the data that followed the May meeting showed inflation at the core level was heating up. But a third of the rise was tied to house prices being excluded from the consumer price index in lieu of rental prices. Fewer people can afford to buy, so they're renting, sending rent prices up, at least temporarily."

"Something else is definitely at work here and I'll be the first to admit I don't know what it is. What I do know is the Fed is dangerously close to triggering deflation. Maybe not of the Great Depression variety, but certainly of an ilk nasty enough to make a lot of us regret that record $12 trillion in debt we've accumulated, much of it in the name of the roofs over our heads."

"If you doubt housing can drag overall prices down, just ask anyone who has lived through the deflation that's plagued Japan for the better part of the last 15 years. The catalyst, they will tell you, was real estate. 'We've seen what this did to Japan,' said Doug Ingram of Dallas-based SAMCO Capital Markets. 'If people are borrowing money to spur the economy and they can no longer do this because home prices have stopped rising, that alone will cause prices to decline.'"

"It's hard to argue that our economy has evolved from one based in agriculture, to one that manufactured goods to one that today occupies itself creating debt. The only explanation I can come up with is the Fed is trying to load up the bullet chamber to fight deflation if housing does get ugly and trigger a recession. The more ammunition they have to lower rates, something Ingram predicts will happen before the year is out, the greater the chance of staving off deflation."

"It may come down to a being able to put up a fight. The Fed can conquer inflation all day long at its current level. But deflation is another story. Fed policy is essentially defunct as the real cost of borrowing, that is, the level of interest rates minus the inflation rate, actually rises when the inflation rate drops Below zero."

"I have to agree with Ingram that the Fed is playing a no-win game. But if it comes down to a recession Fed officials can lick or deflation, something that would end a lot worse than a recession, which would you choose?"

'The Fed can conquer inflation all day long at its current level. But deflation is another story.'

Ms DimMartino is one of the few columnists to address these issues anymore. But I don't agree that inflation is a non-problem that can be over-come with ease. IMO, inflation is excess money creation; sometimes defined as being above GDP growth. The problem the Fed (and othe central banks) now faces is draining that excess from the system. The over-all message of the article is correct; that debt holders will be the one hit hardest.
From Fitch Ratings:

'Rapid GDP growth and the accompanying rise in energy and metals prices have focused global monetary policy makers squarely on inflation risks,' said Brian Coulton, Senior Director in Fitch’s Sovereign Group in London.'

'We are entering a synchronised phase of monetary tightening by the world’s three largest central banks the likes of which has not been seen since 1979.'
They are all right. Inflation in some things (energy), deflation in others (real estate). It's called stagflation and I don't understand why economists can't admit that it is happening.
The good news is, we're at little to no risk of inflation spiking to untenable levels.

I like DiMartino, but on this statement I have to call BS.
I think from a Fed policy perspective Ms. DiMartino is correct, but the problem is that right now Fed policy is playing 2nd fiddle to some larger macroeconomic forces.

One is housing: Yes, the Fed does have the ability to fight inflation by raising rates, but the equal and opposite reaction is a decrease in housing values. Falling real estate prices mean massive decreases in consumer spending, and the very real potential of mortgage bank defaults. The mortgage industry has been playing fast and loose with lending standards, and much of that risk is repackaged and sold to funds. When "fighting inflation" means creating domestic financial instabilities, there's a strong argument for letting a little inflation slip through.

The other external force that the Fed can't control is oil. If oil prices rise, as most people expect they will, we're going to see inflation one way or another. And no amount of Fed tightening is going to prevent a rise in retail and manufacturing prices. Decreasing liquidity and rising oil prices make a deadly brew for an economy.

And on top of all of this there are foreign central banks' efforts to decrease dollar exposure. The Fed is increasingly just one player of many in the dollar game.

We shouldn't forget that the Great Depression was a deflationary phenomenon, and that its principal cause was Fed tightening, and not (as many believe) the crash of 1929.
Di Martino says "hyperinflation" is the more deadly of two evils, but she's chosen "extreme" scenarios to make her point. "Hyperinflation" is of course, a disaster. So a better question would be: "What's the greater of two evils: 'garden-variety inflation', or deflation?" In which case the answer is "deflation".

I think we'll continue to see carefully manipulated official inflation figures accompanying real inflation of 4%-5%. A spike in oil due to geopolitical events would take us even higher.
A while back somebody posted an observation of cash being harder to come by. I was just thinking that it might be even more of problem lately.
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We shouldn't forget that the Great Depression was a deflationary phenomenon, and that its principal cause was Fed tightening, and not (as many believe) the crash of 1929.

I have to disagree. I think the cause of the great depression was the excessive credit creation that preceeded it. People plain and simple borrowed more than they could reasonably repay. The lack of repayment defaulted the debts and decreased the money supply faster than the FED could replace it. We had debt deflations before the FED was created, we had them after. There is no known human institution that can bring nirvana to earth. When people make large scale errors it creates large scale problems.

Why can't people accept that borrowing too much money is a bad idea?
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