Inflation and global monetary tightening

Dan Amoss - Wed 26 Jul, 2006

...Fears of CPI inflation and inflation expectations spiraling out of control are the stated reasons for the current round of global monetary tightening...

 
 
Stock and commodity markets around the world have hit an air pocket on the tough talk by central bankers around the world. Their fears of CPI inflation and inflation expectations spiraling out of control are the stated reasons for the current round of global monetary tightening. Hope springs eternal that a soft landing can be engineered in asset markets without touching off a liquidity crisis.

Yet these synchronous tightening initiatives have repeatedly stood out as the catalyst for Long Term Capital Management - like blowups and stock market meltdowns over the past decade. It amounts to removing the stimulus that set into motion the stock and housing market malinvestments in the first place. This potential market-disrupting event is on the minds of many. Especially those who respect the lessons of history.

Inflation and global monetary tightening: Money migration

Whatever may happen this summer as this tightening campaign plays out, the fact remains that the developing world is industrializing at a rapid pace. Twenty-plus years of perfecting a comparative advantage in financial engineering in lieu of investments in tangible wealth production will grow to haunt the United States. Dan Denning's well-outlined thesis of the Asian "Money Migration" is not dependent upon the fed funds rate, but instead reflects the outsourcing of real wealth production capacity. A hedge fund blowup or a rise in the cost of capital will not end this gradual process.

This line of thought infects many modern academic economists who seek to explain the growth of an enormous credit bubble that is rooted in excessive consumption. The credit bubble will deflate under its own weight as the household savings rate drops further into negative territory. Those who promote government intervention in free markets will be itching to "clean up" the mess left behind by this spending contraction, because there will not be another housing bubble on deck to provide a bailout on the scale we have witnessed in recent years.

The cycle of credit bubble formation, inflation, and bursting finds its origin in a combination of a benefit-for-votes electoral system and an elastic view toward the Constitution. Interventionists hold onto the fallacy that governments can apply knobs and levers to a global economy and interest rate markets that are more complicated than any group of minds can possibly comprehend. What we are left with, after decades of evolution, is a monetary system whereby the debt created by every previous credit bubble must be papered over in true Ponzi fashion in order for the real economy to function at a level that provides full employment.

Credit that is self-financing is one thing, but credit that is taken out in return for a pledge of future payments out of a 30-year household income stream is quite another. BP issuing bonds to finance the extension of an oil well's life in a high-energy-price environment is an example of wise credit use. The profit generated by the extra years of oil production eliminates the credit balance and compensates the company for the risk undertaken by the project. Not to mention it serves as a prudent use of credit to relieve a capacity constraint in the economy.

Inflation and global monetary tightening: House price inflation

Conversely, consumer credit and mortgages are financed through a combination of two options: house price inflation or pledging a percentage of future household income toward installment payments. Lately, the servicing of this debt has been accomplished by option one. Now that this option is near its point of exhaustion, option two must become a larger part of the payment mix. The share of household income devoted to paying down debt must go up in the long run.

The burden of financing the demand for mortgages in recent years has fallen largely on foreign lenders. But there are signs that their cheque books are not unlimited, because of the worries over domestic inflation and the demand for a more Western standard of living. The much-celebrated "We think, they sweat" theory of explaining why foreign creditors should have an insatiable appetite for US Treasury bonds and mortgage-backed securities has an Achilles' heel: the low labour intensity of the 21st-century "knowledge economy."

I wouldn't underestimate the likelihood that the next revolutionary technologies originate in the United States. Instead, I'm focused on the fact that the mortgage and credit bubbles rest on a shaky foundation: the continuation of the US middle class spending far in excess of what it produces. Add this to the deflating value of what many in the middle class produce; nearly all manufacturing, and an increasing number of services, can be done overseas for a fraction of the cost.

For reasons of simplification, not to mention the fact that its case has been successfully argued by the most proven economists in history, I define "inflation" as the Austrian school of economics does: an increase in the supply of money. Prices for goods and services can rise and fall for a variety of reasons: labor strikes, wars, OPEC actions, Hurricane Katrina, recessions, overcapacity, etc. But the ultimate root of inflation is the money that the Fed prints in the course of its open market operations to monetize short-term government securities.

CPI inflation ensues when the growth rate in the money supply exceeds the growth in supply of goods and services. The current CPI does not resemble that of the 1970s, because US dollars are flowing overseas at a rate of $2-3 billion per day. If this fire hose of foreign-bound liquidity decelerates, the pressure on the recently accelerating CPI numbers will increase; if it reverses, it's lights out for the dollar reserve standard.

When the Fed lowers rates, it prints money and buys up Treasury Bills in the banking system, effectively raising the amount of loanable cash on bank balance sheets. This buying pressure bids up T-bill prices, and the inverse price/yield relationship inherent in all interest-bearing securities forces the targeted rates lower.

Banks are not in the business of holding cash with no yield, so they become more aggressive about loaning out the newly printed cash on their books; this is the crucial step where malinvestments often originate. Easy monetary policy inevitably aggravates boom/bust cycles. Consider how many hundreds of thousands of bad mortgages have been written over the past three years. The coming wave of defaults will exacerbate a housing/credit/consumption correction that is long overdue.

Inflation and global monetary tightening: 'Inflation targeting'

To complicate things further, rookie Fed Chairman Ben Bernanke brings to the FOMC his ivory tower "inflation targeting" theory. Chairman Bernanke is trying to sell his compatriots on implementing his theory as a new direction in policy. The theory involves using backward-looking, highly doctored statistics like core CPI to conduct open market operations that raise and lower short-term interest rates.

These rates clearly work their way into the economy with a lag. Therein lies the serious flaw in this theory: In the time between when the doctored core CPI stats are crunched and the policy works its effect on the economy, recessionary conditions may approach quickly. We are in the midst of such a time. Credit addicts are fast approaching withdrawal symptoms. This inflation-targeting policy can be compared to a driver trying to build a legendary NASCAR career by racing while looking mostly through the rearview mirror. Its implementation would only worsen future boom/bust cycles.

Central bankers can talk down markets with their rhetoric, and may even go so far as to cause a financial accident, but every developed economy around the world is dependent on an edifice of credit and derivatives that makes future policy a foregone conclusion: Inflate or die. Before the housing market enters a tailspin, you should remain confident that the Fed and Congress will team up, do a marvelous job at printing money at no cost, and providing it to debtors who are clamoring for it. There is legal precedent for this behaviour in the savings and loan crisis and the New Deal.


Regards,

Dan Amoss, CFA
for The Daily Reckoning
 

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