Tuesday, July 07, 2009

The urgent --flation problem...

Fill in the blank: "in" or "de".  Color me firmly in the "all of the above" camp now.

So, Aaron and I have a casual visit from our FCS district manager today, and she* artfully turns to me at one point and asks, "Since you are so well-informed in these matters, do you think interest rates are going up?"

Too, too cruel. Of course I think interest rates are going up.  It only stands to reason that you can't insert trillions of dollars of liquidity into the banking system without triggering some serious inflation requiring rate increases to staunch.

Only reality seems to be reading a different script. My standing bias was for inflation soon and vigorous. But like other observers, finding any hint of price pressure is hard to do.  In fact, the case is already building for preventing another 1937, when the Fed raised rates and choked what meager recovery was underway.
The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth. 

However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.

Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its “exit strategy”. After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street. In July 1936 the Fed’s board of governors stated that existing excess reserves could “create an injurious credit expansion” and that it had “decided to lock up” those excess reserves “as a measure of prevention”. The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession. [More]
It could be we have an economic transient that can neutralize even enormous stimuli.  To be fair, the stimulus is only slowly being deployed, but its size is prodigious.  So maybe I'm simply early?

Suffice to say I am no longer even mildly convinced interest rates will climb. Nothing has worked like I felt it would. The Chinese still love dollars.   Credit is still not flowing like it was.  And the Fed is in no hurry to curb inflation.

The only comfort I find is in company.
This all boils down to timing. Will Washington be able to stomach the Fed tightening the monetary supply early enough to control inflation? Let's think about that timeline.
Can the Fed begin to tighten in 2009? Since unemployment will likely continue to increase to or hover at double digits through the end of the year, I find that doubtful. Until unemployment is clearly getting better, Washington won't allow the Fed to tighten.
What about 2010? In February, Bernanke's term is up. After that time, Obama can decide if he wants to replace him. He probably will do so, and that replacement will probably be the President's favorite economic guru Larry Summers.
With one of his own advisors as Fed chief, that will make it even harder for the Fed to resist Washington's political pressure. So imagine it's early to mid 2010. Midterm elections season is in full swing. Can you really see Congress and the President allowing Summers to tighten monetary supply and risk an economic recovery just in time for voters to head to the polls? I know I can't.
That leads me to believe that the Fed will be under serious political pressure to keep money supply loose until at least early 2011 -- after the elections. I think with a new Obama-selected Fed chief in there starting in 2010, that political pressure becomes even more relevant.
Will 2011 be soon enough? Time will tell, but if the economy starts improving in early 2010, I worry that may be too late to prevent a greater rate inflation than what we've seen in several decades. [More]
As the mood turns increasingly negative (even if warranted) we fulfill our expectations. Rather than detecting price increases on the horizon, we still can't seem to find a bottom for some goods - like houses. So my memories of the 80's are serving me poorly again. Like my father, I could be preparing for the wrong threat.

* I have discovered the Farm Credit System has very few women in senior management positions.  Too bad.  As someone who has worked with female lending officers for a long time, they are missing an opportunity.


Anonymous said...

inflation or deflation timimg is near impossible to peg.I know in hogs and milk we have severe deflation ...being familiar with the auto sector supplier side the old "big" 3 would at the end of a suppliers contract give them an opportunity to retain the contract with out going through the bidding process again if they would reduce there pricing 5% ,,,so they where in the position too risk losing there contracts or produce at a loss as many suppliers profits where 1 or 2% of sales...(no wonder why Lear filed bankruptcy papers yesterday)and Walmart plays same game with meat and dairy suppliers,,,gear up too produce and then get offered a renewal at below your cost or risk getting no deal...very brutal way of keeping inflation in check...so will we have in or de flation?? regards-kevin

Ron Swanson said...


I appreciate your acknowledgement of the value of women in the management of agriculture. IMHO, commodity associations have also been reluctant to incorporate women into their leadership ranks and may be missing out. On the other hand, I may have a bias as my farming son has four daughters (no sons) whose Grandma has been a strong advocate for women's equity in agriculture for years.