Friday, January 16, 2009

Inflation Expectations and Trepidation

The theoretically correct approach to most flavors of the liquidity trap is not fiscal stimulus.  Nor is it, unless the economy is in an abnormally depressed equilibrium requiring a face slap, quantitative or qualitative monetary policy.  The foolproof solution is to explicitly commit to inflation, prove that you're serious through aggressive action, and demonstrate that you know what to do once you've succeeded.

This is the Fed's playbook, and they are playing by it, coming through both verbally and in action.  The populace is listening, as consumers expect 3.0% annual inflation over the coming 5 years, although down from 5.2% in May.  But Japanese households expected 7% domestic inflation in June, and we know how that worked out.

Those surly bond vigilantes are giving less creed to the Fed's efforts, expecting zero inflation over the same period.  Some inflation expectations are a little less anchored in the blogosphere, to put it gently.

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The world has a way of humbling theories, particularly the foolproof ones.  So far, the operations of the Treasury and Fed have done little to resuscitate market and economic activity or create inflation.  The braggadocio Fed has had precious little traction, though theory would predict immediate and significant impact on market pricing.

The limited impact thus far might not surprise readers.  What good are inflationary expectations in an environment where inflation is not possible?  Regardless of the intent of the US government, the successful reflation of our economy rests not in its hands, but instead in the hands of those who peg their currencies to the dollar, unless and until the US takes some aggressive international actions with significant associated drawbacks.

International investors in the US have myriad strong reasons to resist this reflation.  They expect, for some reason that's beyond me, to be paid back for their extensive reinvestment in the US economy.  They would not enjoy the severe and destabilizing domestic inflation required for US reflation without revaluation.  They also don't want the partial default and export collapse resulting from a revaluation of their currency upwards.

The inertia is powerful, and domestic inflation expectations can't trump this global reality.  But let's assume these inflationary threats do impact the expectations and actions of some actors in the US economy.  What might we expect as a result?

Investors and lenders, who generally receive a fixed coupon on their investment, would naturally demand a higher interest rate to compensate for this expected reflation.  Borrowers expecting similar reflation might be tolerant of that expectation, or they might look at the realistic returns and competition facing their investment and be reluctant to accede to those terms.

Regardless, it's the increased uncertainty about the trajectory of future inflation that causes the most trouble.  The wider the divergence between present reality, natural expectations, and imposed expectations, and the more variability in all these rates, the higher the term premium embedded in a longer loan.  This will put an upward pressure on long real interest rates, which is precisely the opposite of what we wanted to accomplish in the first place.

So much for expectations.  But the supporting action of the US' credibly crazy government for inflation, economic growth, or bust might similarly do harm.  Such dramatic expansion of the Fed's balance sheet, sporadic intervention in myriad markets, and massive deficit spending would seem to me to decrease the confidence in the dollar as a medium of exchange and a store of value.  That should cause the private sector to seek a higher return to justify this additional risk, leading to a negative impact on economic activity.  Who knows who gets sprung next, and what the effect will be on your investment?

Some economic models and empirical work view concerted government intervention positively, even during crisis.  If we had an organized, consistent, and scoped response to this crisis, I would find that outcome plausible.  

We, however, are playing financial Calvinball.  This is never good, as initial assessments reveal.

In short, I think the focus on inflation expectations and the associated, requisite demonstrated willingness to intervene whenever and wherever necessary are self-defeating at best, and quite likely deleterious in our current world.


tuppence said...

"Inflation Expectations and Trepidation" prompted me to read "The US Can't Unilaterally Inflate"

The reasoning is fine, but assumes an absence of exchange and capital controls......... they are coming...... you read it here first!

Detroit Dan said...

Good post, although I'm not quite sure what the future looks like after reading this. Sounds like we'll continue to stumble around for awhile, but then what? Longer term, it seems the international situation (peg to dollar) has to give. Will that change everything?

ndk said...

The reasoning is fine, but assumes an absence of exchange and capital controls......... they are coming...... you read it here first!

I can't suss out how that could help, beyond being the end of the financial world as we know it. China already has capital controls, and dueling exchange rate regimes is the juiciest arbitrage opportunity I can imagine. Could you explain your reasoning, tuppence? It seems far more natural to simply impose tariffs to attack the root of the problem.

Longer term, it seems the international situation (peg to dollar) has to give. Will that change everything?

Something does indeed have to give internationally, Dan, but I don't know if that will be the pegs. If the pegs did give way, then yes, that would change absolutely everything.

But I don't think China will let its currency appreciate more soon. China doesn't sound cooperative, and understandably so. Besides attacking Paulson's "gangster logic" of the global savings glut, there's this gem:

Zhang also criticized the International Monetary Fund for paying too much attention to financial risks in emerging and developing economies and not enough to those of developed countries, "which have a larger impact, especially economies issuing major reserve currencies."

Replay that quote to any southeast Asian friend of yours and they'll be on the floor laughing hysterically.

Detroit Dan said...

Since something has to give with regard to international trade, perhaps this will be THE most important issue for the new Obama Administration. It will be interesting to see how they approach this. Anybody know who will be working on trade besides Geithner?

Detroit Dan said...

In addition to Geithner, there's Larry Summers. Also, from CQ:

President-elect Barack Obama said Friday he would nominate former Dallas Mayor Ron Kirk to the post of U.S. trade representative.

Kirk, who spent years in Washington as a top aide to former senator and Treasury Secretary Lloyd Bentsen, D-Texas, said he believes “a value-driven trade agenda that stays true to our commitment to America’s workers and environmental sustainability is not only consistent with a pro-trade agenda, but it’s also necessary for its success.”

Obama said Kirk “knows there is nothing inconsistent about standing up for free trade and standing up for American workers.”

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