Premature inflationary scares
I got a comment on my previous post on the credibility of inflation warnings on the horizon. I was rather busy these past few days so I couldn’t comment then, so I’ve delayed my response until now. The reader (who assumed an identical namesake for his/her moniker) asked how likely America will find itself in inflation once the recession is over.
The concern stems from something Martin Feldstein warned about earlier in April, namely that unprecedented capital injection by the Fed (helicopter Ben) has caused bank reserves to balloon and inflation may result once liquidity eases and the excess reserves enter circulation when the recession finally ends. I must confess that although I share Krugman’s view that inflationary concerns are premature, I cannot say the same for the long term. But does this mean inflation would necessarily occur? I do not believe so. Here are some reasons why:
Firstly although it’s true that bank reserves have grown considerably due to the credit crunch and banks’ refusal to loan them out, as well as the Fed’s magic spigot, one must remember that at the same time a lot of the same banks’ assets especially those of the CDOs (the ‘toxic’ variety) have been massively devalued. Rob Carnell argued that the massive devaluation of such assets means that banks are not able to collaterallize new lending with them, which is why we have a credit crunch in the first place:
His core point is simple. The collapse of the market for structured financial products and other derivatives has destroyed a significant quantity of credit. Banks that owned them can now loan less, and the now-infamous “toxic waste” cannot be used to collateralize new lending.
Against this backdrop, Mr. Carnell says everything the central banks have done – lower interest rates, buying financial assets, extending maturities for their lending et cetera – pales in significance. Unless they are “extremely careless,” their crisis management need not bake inflation into the cake.
Quantifying this argument precisely is somewhat tricky, so evidence for it has to be inferred. But take a look at figure 11 on p. 11 of the report: Despite everything the Fed has done, private sector lending is still falling.
“Central bank substitution for collapsing private credit generation is only a partial offset – this is not inflationary, just less deflationary,” Mr. Carnell writes.
Krugman made essentially the same point earlier when he wrote that increased government borrowing has yet to make up the fall in private borrowing. Elsewhere, Rob Carnell says that inflation appears to be a distant concern given the massive fall in household wealth levels (about US$12.4 trillion). These includes of course, severe 401(k) losses for which many Americans depend on for their retirement in addition to Social Security. Consumers, feeling poorer than they have ever felt before, would certainly cut back on consumption spending (as they did in Japan a decade earlier), not increase it hence making a deflationary spiral more likely compared to an inflationary one. In support of this, the NYT reported earlier in May that one of the most lasting generational changes we’re likely to see as a consequence of this recession is a fundamental shift in saving and consumption habits:
Fearful of job losses and anxious over housing and stock declines, Americans are squirreling away more of their paychecks than they were before the recession. In the last year, the savings rate — the percentage of after-tax income that people do not spend — has risen to above 4 percent, from virtually zero.
This happens in nearly every recession, and the effect is usually fleeting. Once the economy recovers, Americans revert to more spending and less saving. Over the last 30 years, the savings rate has fluctuated from over 14 percent in the 1970s to negative 2.7 percent in 2005, meaning Americans were spending more than they made.
This time is expected to be different, because the forces that enabled and even egged on consumers to save less and spend more — easy credit and skyrocketing asset values — could be permanently altered by the financial crisis that spun the economy into recession.
“I expect that the savings rate will end up at the end of this recession higher than it was going into it,” said Jonathan A. Parker, a finance professor at the Kellogg School of Management at Northwestern University. “It’s hard to see how it wouldn’t.”
It’s also not evident that inflation in the short term would be anything but good. Greg Mankiw, in an April op-ed, argued that anticipated inflation would motivate borrowing and spending, effectively jumpstarting the economy. The key point to note is that inflation is effectively a tax on holding money, a burden which is lessened when that same amount of money is loaned out with a stated interest rate.
Now the question is, how about after the recession? Now, it’s important to realise that a recession is characterised by two consecutive quarters of negative economic growth and it takes only one quarter of positive growth, no matter how slight, to break out of a recession. However the end of a recession usually does not coincide with the economy operating at full employment. It can be likened to a injured person for whom first aid and other medical measures has stopped the loss of blood, but still has a wound and has yet to recuperate to his normal uninjured state. It is precisely with such in mind that stimulus proponents got it (in my opinion, that is) correct when they push for the package despite knowing that most of it won’t be spent until the worst is over, or maybe until the recession is over. The stimulus package doesn’t take effect only under recessions.
To drive home this point, one might ask a counter-factual question: What would have happened in the absence of interventionist policies such as the stimulus bill? To be sure, it’s hard to answer definitively. But if one notes that the stimulus package was passed just four short months ago (and most of the money has not been spent yet), and that the actual unemployment rate has been much worse than that expected back in Dec 2008 (see graph below) in the absence of a stimulus package, I believe we can all agree on one thing. That it’s hard to conclude that the price of inaction is lower than that of doing something, especially when the opposite appears to be true.
Still the question remains: What can the Fed or government do to withdraw all the excess money in circulation once it appears evident that the economy is on solid footing once more? As reader noted, one way is through interest rate increments and taxes. This includes raising the discount rate, which now stands at an all time low, and the Federal funds rates. There’s actually a whole host of other windows for which banks and other financial entities could obtain credit. The Baseline Scenario lists them here. Apart from making it more difficult for banks to obtain credit, the Fed could also raise reserve requirements for banks, effectively preventing excessive cash reserves from circulating and causing inflation. Of course, like many things, all of these require precision and tighter regulation and closer monitoring. They do not occur naturally to Austrian school followers who are instinctively distrustful of any form of government intrusion.
Apart from the above there’s also the possibility that the emergence of viable alternative world reserve currencies, as we have been seeing recently could cause investors to start dumping the greenback in favour of other currencies such as the Chinese renminbi. Compared to the above concerns, I admit that this would be the most probable cause of inflation should it occur. Capital flight from the US dollar would cause it to depreciate with respect to other world currencies and thereby push up import prices, although such would also increase American export competitiveness and help economic recovery. Like many things in the financial world, the problem is psychological. Fears of a weakened dollar is sufficient to feed a feedback loop which prompts more and more investors to dump their dollars. Perhaps this is where President Franklin Delano Roosevelt’s famous saying “We have nothing to fear but fear itself” becomes quite worrying literally.
At present though, developing countries such as China are not likely to allow their countries’ currencies to appreciate because doing so would hurt their exports and hence their major source of economic growth. How long such a view would persist is anyone’s guess. As this NYT article notes, while we’re not likely to see American consumers return to their binge consumption habits any time soon, there’s hardly anyone else who are likely to fill those shoes soon.
Just my two cents above. Feel free to comment.
Here are some links on what professional economists think about inflation fears:
Personally I feel that the entire ongoing Romer roundtable on whether policy makers have learnt the lessons of 1937 (of cutting back too soon by FDR) by a group of economists is worth reading
A Long Way to Inflation by Andy Harless
Deflation? by Prof Greg Mankiw
One Third of the Prices within the CPI Fell Last Month by Prof Mark Thoma
Why the Fed Isn’t Igniting Inflation Business Week
Inflation sparks glowing on the horizon Reuters
Towards an Inflationary Depression Global Research
Don’t Expect Hyperinflation for U.S. Economy Seeking Alpha
Inflation or Deflation, Which is More Likely? The Market Oracle
Lower Inflation Liberates the Fed Wachovia Research Team