Two Inflationary Tail Risks For US Investors

Mish

Lacy Hunt at Hoisington Management has two potential sources of inflation on his mind.

Third Quarter Outlook

Please consider the Hoisington Quarterly Review and Outlook for the third quarter of 2020.

Lacy Hunt starts off with conditions central banks must meet to stimulate the economy.

Four Conditions

  1. The Fed must be able to control the  monetary base by increasing its liabilities
  2. The Fed’s power to stimulate economic conditions is a stable relationship between the monetary base and the money supply, M2.
  3. The velocity of money (V) must be stable, although not constant. If V is stable, then changes in M2 will control swings in nominal GDP.
  4. The Fed must have wide latitude to lower the short-term policy interest rate. It had been long recognized that if short-term rates approached the zero bound, monetary capabilities would be diminished.

Monetary Base and Velocity Discussion

The Fed can of course increase the monetary base at will. 

Regarding Velocity, Hunt's statement "If V is stable, then changes in M2 will control swings in nominal GDP," is accurate, by definition. 

V = GDP / M2

However, velocity has no life of its own. It is a result, not a cause. The Fed cannot control velocity now, nor could it ever.

Velocity can rise of fall with rising or falling prices or rising or falling GDP. 

For discussion, please see If the Velocity of Money Picks Up Will Inflation Soar?

Latitude to Cut Rates

Point 4 is the key. The Fed has no latitude to cut rates.

Unlike the ECB, the Fed is even aware of this. They are fearful of cutting rates below the ELB "Effective Lower Bound" 

ELB is the point at which further cuts are detrimental in the long run. 

ELB Discussion

  1. June 4, 2019: Powell Ready to Cut Rates to "Effective Lower Bound" via "Conventional" Policy
  2. September 25, 2019: In Search of the Effective Lower Bound
  3. September 22, 2019: ECB's New Interest Rate Policy "As Long As It Takes" Huge Failure Already

A Fed study in November of 2019 on Effective Lower Bound Risk confirmed what I had to say in the above links. 

In an empirically rich model calibrated to match key features of the U.S. economy, we find that the tail risk induced by the ELB causes inflation to undershoot the target rate of 2 percent by as much as 50 basis points at the economy's risky steady state. Our model suggests that achieving the inflation target may be more difficult now than before the Great Recession.

I was not aware of the Fed study on the ELB until now. It came up when I searched for my ELB discussion to add to what Lacy had to say.

Five Negative Impacts of ECB's Negative Rates

  1. Negative rates further weakened already weak European banking system by charging them interest on excess reserves.
  2. Negative rates kept zombie companies alive at the expense of productive ones. 
  3. Negative rates destroyed bank profits. 
  4. Negative rates added to unproductive long term debt.
  5. Negative rates increased speculation.

As I have pointed out on numerous occasions, 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. 

Thus, I highly doubt the Fed takes interest rates below zero. However, the Fed may make other huge policy errors.

Only One Condition the Fed Can Control

Currently, of these four conditions, only  the first one prevails, and it is the least important of the four. The Fed can control the monetary base by increasing its liabilities (bank reserves). The three other, and far more critical, conditions are no longer present due to the extreme over-indebtedness of the U.S. economy. 

Thus, monetary policy is left with one-sided capabilities i.e., they can restrain economic activity by reducing reserves and raising rates, but they are not capable of stimulating economic activity to any significant degree.

Indeed, the risk is that the Fed has already overshot the ELB as that rate is somewhat above zero. 

It certainly is not less than zero as evidenced by the miserable results obtained by the ECB and Bank of Japan.  

What about inflation risks?

With that question, let's once again turn back to Lacy.

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 change in the Fed’s modus operandi. The first risk would change the short-run trajectory of the economy. This better growth, although short lived, could place transitory upward pressure on interest rates in a fashion that  has been experienced many times. Over the longer run, disinflation would prevail and the downward trend in Treasury yields would resume. 

The second risk would bring a rising inflationary dynamic into the picture, potentially becoming much more consequential. As this dissatisfaction intensifies, either de jure or de facto, the Federal Reserve’s liabilities could be made legal tender, or a medium of exchange. Already, the Fed has taken actions that appear to exceed the limits of the Federal Reserve Act under the exigent circumstances clause, but so far, they are still lending and not directly funding the expenditures of the government 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 liabilities were made a medium of exchange, the inflation rate would rise and inflationary expectations would move ahead of actual inflation. In due course, Gresham’s law could be triggered as individuals move to hold commodities that can be consumed or traded for consumable items. This would result in a massive decline in productivity, thus real growth and the standard of living would fall as inflation escalates. 

As long as the federal government’s policy prescription is ever higher levels of debt, the path toward disinflation will hold and long Treasury bonds will be the preferred area of the curve. The continuing shift in economic conditions over the past forty years has necessitated several dramatic changes in our yield curve positioning. That flexibility remains constant. 

Looking for Inflation in All the Wrong Places

Those are very important paragraphs by 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 all the wrong places.

Inflation exists in asset prices of stocks and junk bonds. Speculation is rampant. Robinhood has turned millions of millennials into day traders who are now convinced that stock prices only go up. 

Meanwhile the economic bubbles keep expanding and when they bust we will see a deflationary credit bust that the Fed ought to fear instead of the CPI deflation which the Fed foolishly does fear.

Economic Challenge to Keynesians

Of all the widely believed but patently false economic beliefs is the absurd notion that falling consumer prices are bad for the economy and something must be done about them.

My Challenge to Keynesians “Prove Rising Prices Provide an Overall Economic Benefit” has gone unanswered.

BIS Deflation Study

The BIS did a historical study and found routine deflation was not any problem at all.

“Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the BIS study.

For a discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?

Conclusion

Central banks are fighting a deflation boogie man that does not even exist, creating a debt deflation monster in the process.

The tail risk is the Fed goes too far down the rabbit hole unleashing a different kind of monster.

Mish

Comments (11)
No. 1-8
Dodge Demon
Dodge Demon

Walk me through a somewhat worse real estate asset deflation and foreclosure scenario over the next 3 years as compared to 2008-2011. Who eats the defaults on the debt?

Flatlaxity
Flatlaxity

One cannot argue that Quantitative Easing begets Deflation/Disinflation. However, that’s in the long run. Dr. Hunt does not describe how we get there – only that it will come. He does acknowledge that in the short term – however long that is – that with QE that higher economic growth and interest rate will occur “...as has been experienced many times…”.

He also entertains the possibility with continuing QE we could lapse over into a hyperinflation scenario whereby Fed liabilities become directly spendable. He talks of individuals correspondingly moving into consumable/spendable commodities (e.g., food stuffs and gold.)

However, while we’ve increased our government debt/GDP up to 130 percent or so, we’re still a long ways from the Japanese experience with up to 250 percent. While Japan’s economy is progressing, it is doing so at a lower rate, or 40 percent below the US average annual GDP growth rate since 1990. But the Japanese economy is still very viable.

Then, there’s our switch over to fiscal spending directed largely to the individual consumer - which has been significantly stimulative. Also, the decrease in interest rates has resulted in higher home construction, refinancing and HELOC loans. Unlike the Europeans and East Asians, the US consumer will spend the dollars offered. I can think of the WWII desolation caused to Europe and Asia, and not to the US, as a principal reason.

So…we’ve got a willing American consumer and more fiscal spending out there. We’re still going to be in the “here” scenario before we get to Hunt’s “there.”

Roger_Ramjet
Roger_Ramjet

History is littered with notable acts of desperation, usually occurring during the final throes of, mostly military, campaigns. Pickett's charge during the Civil War is one notable, and tragic, act of desperation on the part of Lee.

The Fed has been conducting its own war on deflation for several decades now, and as their policies become less and less effective over time, the Fed has been forced to resort to even greater and extreme acts of desperation. The state of their monetary policies is already at an extreme level of perversion.

That being said, I don't think we have reached the pinnacle of Fed desperation, yet. These guys have become quite proficient at desperate acts. In fact, the Fed's so called "tool box" does not contain any productive monetary tools, just more desperate acts yet to be implemented.

compsult
compsult

Appreciate your analysis as always Mish
Lacy Hunt cites a study that shows that austerity is the only solution to over indebtedness. And that if the Fed crosses the Rubicon to become a spender instead of just a lender, hyperinflation will be the eventual result

Maximus_Minimus
Maximus_Minimus

"The Fed can see that negative interest rates in Europe and Japan were counterproductive. "
Just because something didn't work there, doesn't mean they're not going to try it in the US. I mean, what's next; claim that they posses intellectual integrity?

hfom
hfom

What are your views on the latest unconventional monetary policy "dual rates"?

Salmo Trutta
Salmo Trutta

Vt can't be stable. An increase in the proportion of bank-held savings destroys money velocity. Banks pay for their earning assets with new money - not existing deposits.

Dr. Philip George's "corrected" equation proves this. It’s stock vs. flow. As Dr. Philip George says; "“When interest rates go up, flows into savings and time deposits increase” ( the ratio of M1 to the sum of 12 months savings ).

Salmo Trutta
Salmo Trutta

re: "The second requirement of the Fed’s power to stimulate economic conditions is a stable relationship between the monetary base (a consolidation of the Fed and Treasury balance sheets) and the money supply, M2"

Remunerating IBDDs emasculated the FED's "open market power". Unlike Treasury issuance, because the belligerent bifurcation (the mis-aligned distribution of sales and purchases of debt by the FRB-NY’s trading desk and its customers/counter-parties is largely unpredictable, so too now is the volume and rate of expansion in the money stock. FOMC policy has now been capriciously undermined - by turning nonearning excess reserves into bank earning assets.

This is in direct contrast to targeting: RPDs (reserves for private nonbank deposits), and by using non-borrowed reserves as its operating method (predating Paul Volcker’s October 6, 1979 pronouncement on the Saturday before Columbus Day), as Paul Meek’s (FRB-NY assistant V.P. of OMOs and Treasury issues), described in his 3rd edition of “Open Market Operations” published in 1974.
This adds up to an obdurate apparatus that the Fed cannot monitor, much less control, even on a month-to-month basis.

What the net expansion of the money stock will be, as a consequence of any given addition or subtraction in Federal Reserve Bank credit, nobody can forecast until long after the fact. And the whole process is now initiated by the member banks, via proffered bankable opportunities, not by the monetary authorities.


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