Not Your Father's Inflation

My previous post talked about what is going to happen with the recession, but I didn't spend too much time on monetary policy and what the Fed will do. This is sort of unfortunate, as the Fed has a very big role to play. In fact, it probably has an even bigger role than the Treasury or the Obama Administration in ending this recession. So, now that I have considered the fiscal side of things, let's look at the monetary side.

Without a doubt, we are currently in a deflationary scenario, or at least very minimal inflation. The sort of interesting thing is that while the prices of goods and services haven't really fallen in the past few months, the asset price deflation has had a profound impact on the economy. For at least the next few months we can expect more of the same.

Deflation in modern economies is bad, first because prices are sticky (for example, wages go up much more easily than they go down), second because deflation increases people's real (i.e., inflation-adjusted) debt burden, and third because deflation can lead to a spiral of falling prices as people keep on waiting to buy things, knowing that prices next month will be even lower. This is very bad for production and employment. Knowing this, what options does the Fed have available? It's already taken a few steps that can tell us what it plans on doing.

The Fed desperately wants to avoid deflation for the reasons stated above. Until recently, it focused on trying to get the frozen credit markets moving again through various programs such as the Term Asset-based Securities Lending Facility (TALF). There seems to have been a few signs that it has been working. The commercial paper market, vitally important for businesses in funding their day-to-day activities, has more or less recovered. But what is really important is the announcement the Fed made about a month ago, declaring that it would buy hundreds of billions of dollars worth of Treasury bonds. The Fed has effectively declared a policy of quantitative easing -- in other words, the Fed is going to print its way out of the recession.

I gave several reasons in my previous post as to why the Fed would want inflation, but it bears some repeating here. First, inflation "greases the wheels," so to speak. Inflation would get things moving again. The credit markets would unfreeze, and companies would finally be able to get the credit they need. Second, there's too much debt in the US. The easiest way to solve that problem is to inflate. Of course, there are plenty of problems with inflation, but if it had to choose between the two, the Fed will always choose inflation over deflation.

The TALF really only addresses the liquidity problem of the asset-backed securities markets. A completely liquid ABS market, however, is not going to stop a recession. This is where quantitative easing comes in. By buying Treasuries, the Fed is deliberately pushing the interest rate down. Its hope is that with such low rates, companies will be able to borrow money in these times.

Japan in the 1990s also adopted a policy of quantitative easing, and it still hasn't recovered from its bubble. So why worry about QE? I have three reasons. First, Japan never really tried hard enough. The simple fact that deflation was still happening until very recently is proof that Japan didn't print enough money. After all, printing more money is by definition inflationary. The US, I hope, has learned its lesson. The Fed will look at Japan and see that they can't afford to make the same mistake; they will have to print more. Second, I think a major reason why Japan didn't try harder was because the Japanese are big savers. When a large portion of the population is savers, you can't exactly go for deliberate inflation without incurring the wrath of your constituency. The US, on the other hand, has had a dismal savings rate. We even had a negative savings rate not too long ago. The government will feel much less compunction than Japan did in trying to inflate its way out of the recession. Finally, partly because of incompetence, partly out of politics, but mostly because of an unavoidable lag between the Fed's actions and its effect on the market, the Fed will not be able to control the money supply as effectively as it would like. Thus, the Fed will end up printing too much money, and when it tries to tighten policy, it will be too little, too late. The Fed always has a problem of reacting too late to a situation. Take for example the Fed leaving rates too low for too long in 2004 or so. It's completely unavoidable, though. There is always a lag, usually between one and two quarters, from when the Fed decides on an action -- raising rates, for example -- to when that action will finish filtering its way through the market. Given this lag, the Fed would essentially have to do the impossible: It would have to be able to forecast what would happen 6 months from now based on today's data.

Even if it could do that, its actions would be completely counterintuitive to the populace. Currently, the Fed Funds rate is between 0% and .25%. If the Fed sees a recovery by December of this year, then it should start raising rates in June so that its policy can match the market correctly. But in June, the economy is still declining, and the Fed decides to raise rates!? The Fed would not able to survive the onslaught of criticism and outrage from people and politicians. And that's assuming the Fed knew with certainty that the economy would recover in December. The more likely thing is that it has a feeling that it might recover, but it could be wrong. If it's wrong, though, and the economy doesn't recover until March 2010, then the Fed will be raising rates at precisely the wrong time. That would be the worst possible thing to do, raising rates while the economy is still declining. So the Fed will always act too late.

Why did I title this post "Not Your Father's Inflation?" Using the three scenarios I outlined in my last post, let's look at what the Fed would do in each case.

1. Recovery soon
If the economy is going to start recovering by the fourth quarter of this year, then the Fed should actually be ready to start raising rates soon. We know that this won't happen though; the Fed won't start raising rates until it sees actual proof that the economy is improving, meaning that the Fed won't be taking any action until midsummer at the earliest. Thus, we'll have several months where monetary policy is too loose. However, it's not exactly clear if that would have any bad effects on the economy. On the one hand, we'll probably have anemic growth even after the recession ends, so the easy money will simply make things a little less anemic. On the other hand, the Fed has pumped astronomical amounts of money into the system. The only reason why we haven't had massive inflation so far is because the velocity of money has been falling even faster. Once the economy recovers, the velocity of money will start to recover too. And since there is so much money sloshing around now, a small rise in velocity will have a much bigger effect on inflation than before. We could end with a situation where we have no inflation one day and then lots of inflation the next. Similar to interest rates, the Fed will be acting late in turning off the spigot of quantitative easing , thus ensuring that this scenario is a distinct possibility.

2. Recovery in 2010 or 2011
In our second scenario, the recovery would not occur until much later, but overall, I don't see much of a difference in what the Fed would do or what would happen. I would like to consider, though, how much inflation we could have as a result of the Fed's actions. If things play out as I described above, then we could have anything from bad inflation (8%) to very bad inflation (15%) to a hyperinflation (30%+). Much of this will depend on how much the velocity of money recovers.

3. The Greater Depression
As I mentioned in my section in the previous post on the Greater Depression, the government, if faced with this scenario, has two choices: It can endure the years of economic suffering under a crippling deflation, or it can hyperinflate its way out. I would place my bets on the latter choice. In that case, we'll soon be ruing the day when gas cost only $4 a gallon. The government might start with a "stimulus check" of $10,000 or $20,000 for every taxpayer. Everyone will feel richer, and for a very brief moment, it will look like things are actually recovering, with asset markets unfreezing, people finding jobs, and even banks making money again. But this is merely the illusion of prosperity. People sooner or later will realize that if everyone has more money, then everyone has more money to pay for things. What starts out as $3 cup of coffee will become $4, then $5, then $7, then $10, then $15, and on and on until the currency collapses. The flow of money that will slowly make its way through the economy, lifting all boats at first, will quickly turn into an uncontrollable tsunami that mercilessly kills all without an ark. Those with any savings will find that their decades' worth of hard work has become worthless. On the other hand, anyone with a mortgage will gladly trade $20 bread or $50 milk for a complete repudiation of his debt.

The endgame? If we're looking at bad inflation for the future, then you should have some money in commodities like gold or oil, but your life will be business as usual for the most part. The Fed might have some trouble controlling the inflationary beast, and maybe we'll even have a 70s-style period of economic malaise, but nobody gets hurt. If we're looking at hyperinflation, then I'm sorry to say that you're screwed... unless you happen to be one of the many who owe more money on your home than it's worth, or one of the few who judiciously put some cash into the shiny, yellow metal.

In either case, it would behoove you to carry a little bit of the barbarous relic. We're looking at some barbaric times ahead.