With the recent weakness in the economy many economists have warned that the US faces a deflationary future. Their solution is to print money to counter any deflationary forces. As readers will know, I strongly disagree with this idea because there is no deflation. I am not going to get into the inflation/deflation debate because it is not productive and both sides remain obstinate. However I will note that Fed President Hoenig made a speech yesterday which noted:
The way I see it the goal of 0% interest rates is to create another asset bubble to bail out the economy. The Fed may claim that this is not their intention, but actions speak louder than words. They understand that the real economy has been permanently disabled thanks to the financial crisis and housing bubble. Under their line of reasoning the only thing that can cause a temporary recovery in the economy would be another credit bubble,which is bigger than the housing bubble. It remains to be seen whether they can accomplish this because the demand for credit throughout society (businesses, consumers, etc) is declining at a rapid rate. Another problem is that the banking system is insolvent which means banks are not going to be extending credit and loans like they did before. We know that 0% interests rates encourage speculation as people look for alternatives to 0%. However, most Americans have already given up on stocks and are piling into bonds despite the threat of inflation and low returns on 10 year Treasuries. According to traditional economic thinking this is the exact opposite of what you would expect rational people to do. They should be moving their assets into riskier investments rather than safer ones. If these trends continue expect more economic stagflation as the economy limps along and high commodity prices ensure inflation. It remains to be seen whether the Fed will get their wish of another credit bubble.
Black Swan Insights
One final note about deflation: The consumer price index was a mere 18 in 1945 but was 172 at the start of this century. Today, despite our most recent crisis, the CPI is over 219. Not once during more than half a century has the index systematically declined. I find no evidence that deflation is the most serious threat to the recovery today.People commonly mistake asset price deflation with general price deflation. Asset price deflation is part of the credit cycle. When a credit bubble bursts (e.g. housing market), prices have to fall back to a proper clearing level set by the market. However, there is a certain group of economists, who believe that the Federal Reserve should never let this process occur. Instead they postulate that the Fed should debase the dollar through inflation, which increases the nominal price of assets. They argue that the "deflationary risk" of falling prices is to great and that the Fed should do everything in their power to prevent it. This is why the Fed will not allow home prices to fall to their natural level. One other aspect of Hoenig's speech I found noteworthy was his discussion on negative real interest rates and why it it destructive to the economy. He mentioned that the Fed made the mistake in 2003-2004 of keeping interest rates artificially low for too long, which led to a speculative housing bubble. What I find unbelievable is that the Federal Reserve refuses to learn from their own mistakes. They admit that low interest rates create dangerous price bubbles, but at the same time have lowered interest rates to 0%. They have kept rates at all time lows for over a year even though they know this is going to cause unintended problems in the future. What the hell are they thinking at the Fed?
The way I see it the goal of 0% interest rates is to create another asset bubble to bail out the economy. The Fed may claim that this is not their intention, but actions speak louder than words. They understand that the real economy has been permanently disabled thanks to the financial crisis and housing bubble. Under their line of reasoning the only thing that can cause a temporary recovery in the economy would be another credit bubble,which is bigger than the housing bubble. It remains to be seen whether they can accomplish this because the demand for credit throughout society (businesses, consumers, etc) is declining at a rapid rate. Another problem is that the banking system is insolvent which means banks are not going to be extending credit and loans like they did before. We know that 0% interests rates encourage speculation as people look for alternatives to 0%. However, most Americans have already given up on stocks and are piling into bonds despite the threat of inflation and low returns on 10 year Treasuries. According to traditional economic thinking this is the exact opposite of what you would expect rational people to do. They should be moving their assets into riskier investments rather than safer ones. If these trends continue expect more economic stagflation as the economy limps along and high commodity prices ensure inflation. It remains to be seen whether the Fed will get their wish of another credit bubble.
Black Swan Insights
Deflation is not as bad as hyperinflation.
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