Ms. Yellen And Inflation

No “Inflation Worries”

Ahead of the Jackson Hole pow-wow, where a bunch of central bankers and establishment-approved intellectuals advising them will soon meet, it may be worth taking a look at what motivates the policies of the new Fed chair. On August 12, Bloomberg reported – employing its inimitable style of headlines construction -  that “Yellen resolved to avoid raising rates too soon, fearing downturn”. Bloomberg elaborates:

“Approaching a historic turn in U.S. monetary policy, Janet Yellen has staked her tenure as chair of the Federal Reserve on a simple principle: she'd rather fight inflation than another economic downturn.

Interviews with current and former Fed officials indicate that Yellen and core decision-makers at the U.S. central bank are determined not to raise interest rates too early and risk hurting the fragile U.S. economy.

It's a commitment that will be vigorously tested in coming months as pressure builds inside the Fed, among Republicans on Capitol Hill, and perhaps even in financial markets, for the Fed to acknowledge a strengthening U.S. economy with its first interest-rate increase in more than eight years. A global central bankers' conference in Jackson Hole, Wyoming next week will give Yellen a major stage on which to press her case.”

To this it must be kept in mind that the definition of “inflation” has been twisted over time to represent one of its possible effects rather than the thing itself. Prices obviously cannot be “inflated” – they can either rise or fall. What can be inflated is the money supply, and until large parts of the science of economics began to retrogress from the late 1930s onward, this was precisely what economists held to be the meaning of the term. In short, “inflation” once designated the increase in the money supply. However, Bloomberg, Ms. Yellen and her fellow Fed members use the term “inflation” to refer to the mythical “general price level”, specifically the rate of change of consumer prices.

Why is there no such thing as the “general price level”? Even our largely disembodied digital money is essentially a good with its own supply-demand characteristics. If one compares the array of price ratios it forms with other goods against which it is exchanged, there are two problems:

Firstly, since both money and the goods one exchanges it for are subject to the laws of supply and demand, there exists no fixed yardstick – if one e.g. looks at the money price of oil, it is simply not possible to know to what extent its height is influenced by the supply of and demand for money, or the supply of and demand for oil.

The second problem is that by adding up an entire array of money prices of disparate goods, one arrives at a number that is devoid of logic.

To see why consider the following sentence: “1/25,000 of a car, plus one movie ticket, plus two pounds of potatoes, plus one fifth of a massage, plus ½ of a haircut, plus 1/500 of a personal computer, equals….” -  when it is put in this way, it should be immediately obvious what the problem is. An “average” of cars, potatoes, haircuts, etc. is inherently meaningless.

With that out of the way, one may concede that such data points as CPI, in spite of being fundamentally nonsensical numbers, have some limited value to the extent that they indicate general trends in the ever declining purchasing power of today's money. Unfortunately, CPI data cannot be meaningfully compared over long stretches of time. This is firstly due to the fact that the composition of goods and services that are produced and consumed continually changes (for instance, the 1905 price of buggy whips and gas lamps is entirely meaningless for today's economy). For another thing, because a wide range of the government's so-called “entitlement expenditures” are tied to CPI, there has been a strong incentive to fiddle with the formula used to calculate CPI, so as to make CPI rates of change appear as low as possible. If the same formula that was used to calculate it in e.g. 1980 were still used today, economists would probably be in complete agreement that there is in fact an enormous “inflation problem”.

If the definition of “inflation” had not been deliberately altered to describe one possible effect of inflation rather than what it really is (no simple, easily understood term is available anymore for the cause of rising prices), they would agree even more:

The “inflation non-problem” illustrated in terms of broad US money supply TMS-2 (this chart doesn't include memorandum items, which we roughly estimate to add another $50 bn. to the total). At its current level of over $10.3 trillion, it is less than $300 bn. away from being 100% above the level at the beginning of 2008. Readers may notice that under vaunted “inflation fighter” Paul Volcker, the money supply roughly doubled as well – click to enlarge.

Errors, Misguided Confidence and Sheer Hubris

Ms. Yellen and her fellow Fed doves hold numerous erroneous beliefs. The most surreal of these beliefs is the idea that the economy can be “improved” by their interventions and that the market economy in fact cannot function properly without constant interference by central planning bureaucrats. The ideal system conforming to this idea would presumably be the Soviet GOSPLAN system, as there would no longer be any “market anarchy” at all – instead, everything would be planned meticulously by bureaucrats and Utopia would finally be here.

Another error, which is a derivative of the first, is that the Fed has things “under control”.  It is fairly easy to show empirically that is not true, one only has to consider the not-so-distant financial and economic crash of 2008. If our vaunted central planners have everything under control, why did it happen? Was it part of their plan?

Apparently the current concrete manifestation of this belief is that “inflation is not a problem and should it ever become one, it will be easy to fight it”. This faith presumably stems from the experiences of the Volcker era, which today's central planners believe to demonstrate how “easy” it is to bring “inflation” (i.e., an obvious and fast decline in money's purchasing power in this case) under control. The Bloomberg report hammers this point home:

“She is able to deeply question staff and colleagues about the fine points of their presentations, and so far has been able to forge consensus statements that have satisfied the Fed hawks most concerned about the inflation threat while keeping the central bank focused more on employment.

The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession. Inflation, on the other hand, is a familiar foe that Fed officials say they are confident they can control with conventional policy tools.

"If the Fed were to generate too much economic growth and higher inflation, that is a much better situation to be in than one of a faltering economic recovery and the need to rely even more on unconventional tools," said David Stockton, the Fed's chief economist until 2011 who is now a senior fellow at the Peterson Institute for International Economics.

"The Fed knows how to contain inflation if it is moving," he said, while the impact at this point of another downturn "are more uncertain and hard to counter."

The risks of moving too soon, Stockton and others in and outside the Fed say, include snuffing out an already tepid housing market recovery with higher mortgage rates, depressing business investment and durable goods purchases, and triggering sudden declines in asset prices.”

This certainly strikes us as tempting faith. In the mid 2000ds, we also thought that a deflationary resolution of the credit bubble was quite likely – this was based on the idea that at the time, the ratio of fiduciary media (this is to say, bank deposits created from thin air for which no reserves in the form of standard money exist) to reserves was extremely high. If the monetary system had still been based on gold, this situation would without a doubt have eventually led to  a major deflation of the broadly conceived money supply, as defaults and debt repayments combined would have wiped out a large part of the extant fiduciary media once the bust was underway.

However, we have a pure fiat money system today, with a central bank at its center that is not constrained at all in terms of how much money it can create at will, essentially at the push of a button. As a result of several “QE” iterations, bank reserves have swelled and now comprise more than 25% of the extant broad money supply. In short, the ratio of covered to uncovered money substitutes has risen significantly. As a result, banks have far less reason to fear a run on demand deposits and won't be forced to call back outstanding credit or sell assets as quickly as would be the case if their reserves were at the extremely low levels that obtained prior to the last crisis.

The proportion of covered to uncovered money substitutes has risen sharply – click to enlarge.

The widespread belief that it will be easy for the Fed to put the “inflation genie” back into the bottle should it appear on the scene, suffers from numerous defects. One of them is that leads and lags are apparently not taken into account. Enormous monetary inflation has already taken place.  Should the demand for money unexpectedly decline (if a critical mass of people for instance becomes convinced that the current excessive inflationary policy will be continued indefinitely), a big elephant in the form of a very large hot potato will found to be already in the room.

Another point is that it is stressed throughout the Bloomberg article, that hiking interest rates would “endanger the fragile economic recovery”. In other words, it is feared that a great many capital-consuming bubble activities would have to be abandoned and that incidentally, securities prices would come back down to earth to reflect reality rather than the current policy-induced fantasy. The obvious question is though: in what way would the situation be different if consumer prices were to start increasing at a rate that would require the central bank to switch gears to “fight inflation”?

Would the economy not come under pressure in this case as well – and would it then not happen under significantly worse circumstances? What would then be considered the “appropriate policy choice”? After all, the choice would once again come down to either attempting to slow down the decline in money's purchasing power, or keeping economic activities that depend on loose monetary policy on life support. It would be exactly the same problem that is held to exist right now, except that it would be even worse in several respects.

Lastly, here is a chart that shows how the distortion in relative prices the Fed's policy has caused has influenced the economy's production structure thus far:

The production of capital goods has risen sharply relative to consumer goods production – click to enlarge.

When the boom ends, the movement in relative prices, that has caused factors of production to be increasingly moved toward capital goods production from consumer goods production, will reverse again. Whether this will involve a rise in consumer goods prices in absolute terms is something we cannot apodictically predict in advance. However, it is a possibility that can definitely not be ruled out. As a friend recently pointed out to us, the fact that real incomes have declined a great deal should eventually lead to more and more demands on the part of labor to increase the nominal level of wages. At that point, the effect of the vast money supply inflation to date may well begin to shift away from asset prices to other prices in the economy. Then Ms. Yellen's “non-problem” could quickly become a rather very big problem. The Bloomberg article mentions this possibility in passing, calling it “the other scary scenario”:

“The other scary scenario is that a bout of swifter-than-expected inflation could erode three decades of hard-earned confidence that prices will remain under control, which in turn could make it easier for higher inflation to take firm root. The Fed's more hawkish officials also worry that the longer rates remain ultra low the more likely it is that troublesome financial bubbles will form.”

We should point out here that it is way too late to worry whether “troublesome financial bubbles will form”, as that has already happened. Evidently, almost no-one expects the “other scary scenario” to happen though. As a general rule of thumb, this means that the probability of it happening has vastly increased.

Conclusion

Ms. Yellen seems prepared to tolerate both what she recently referred to as “noise” (i.e. a larger than expected increase in consumer prices) and the growth of large asset bubbles, because she believes loose monetary policy is needed to lower unemployment. In the short term, this effect can indeed be achieved by a combination of bubble activities springing up on the back of loose monetary policy and a decline in the real level of wages – as long as prices of goods and services increase faster than wages, that is.

The first of these effects cannot be kept up indefinitely, as more and more capital and real wealth are going to be consumed relative to genuine new wealth creation. The second effect has indeed occurred in recent years, but there is no economic law that can be relied upon that ensures it will always happen or will continue to happen. Mainly this effect depends on the gullibility of wage earners, which per historical experience has its limits.

The potential danger that a large decline in money's purchasing power could occur continues to be played down by the financial press as well as by numerous central economic planners and their advisors.

This is by itself a rather worrisome development. It is not unreasonable to assume that the next bust could develop very differently from the last one in terms of what happens to prices in the economy. Not least this is so because the Fed and other central banks will likely open the spigots much faster than last time around. Of course, at the moment they aren't even contemplating closing the spigots yet, although the end of “QE” already does represent a somewhat tighter policy stance.

Charts by: St. Louis Federal Reserve Research