The Great Inflation Debate: What's it all about (Part 1)

Had a phone call this morning from a colleague who has been reading this blog lately and he wanted me to explain to him my thoughts on inflation.

He has read the blog, read other blogs and has been trying to get a grip on why people are concerned about the threat of inflation. "A bunch of people are saying it isn't a concern. A lot of others are saying we should be 'very afraid."

In that he has a very large mortgage coming due for renewal, he is wisely trying to understand the issue.

The fact of the matter is that Canadian interest rates are directly tied into what is happening in the United States. As we saw last week, despite the fact the Bank of Canada never changed it's key lending rate, Canadian Banks raised their rates based on yields for 30 year US Treasuries having risen. The yield on the 30 year Treasury is directly linked to US mortgage rates.

So what happens in the US directly affects us here in Canada, whether we like it or not.

US Bond and Treasury sales are the way the United States government finances it's balance sheet. They come up with a budget, raise money through taxes, and any shortfall (the deficit) has to be covered by selling bonds and treasury bills.

As these bonds and treasuries are sold, a yield (or interest rate) is attached to them. If buyers are scarce, the yield has to be raised to sell them.

Higher yields mean the cost of borrowing money rises. This trickles down to the money lent by banks to you for your mortgage.

The United States Federal Treasury has kept interest rates close to zero since last December. They have achieved that through a number of means including buying their own Treasuries and bonds by (in effect) printing more money. The Fed has also lent money to financial firms in return for all sorts of assets in order to keep credit flowing through the economy.

When any other nation does this, confidence in their currency collapses resulting in hyperinflation.

So how can the US get away with it? Because the US dollar and economy has been so strong for 60 years that the US dollar has been adopted by the world as it's reserve currency. Everyone has such faith in the US that it has become the foundation upon which all other currencies are traded.

And the United States has been able to leverage that status to their advantage while keeping International confidence in their policies high.

International confidence aside, some analysts fear that as the United States swells bank reserves well above typical levels with the printing of additional money, these reserves will serve as rocket fuel for future inflation. Simply put, excessive money in the banks will lead to runaway consumer inflation.

Those who dispute the future inflation argument assert that the reserves are so large because the demand is large. When demand drops off, that money will not find it's way into the general economy to fuel inflation because the Fed will be able to drain the reserves off.

And that's the crux of the whole issue: Can the Fed do that? Can they remove the reserves before the funds find their way into general circulation and fuel inflation?

We know that the Fed's balance sheet has exploded (to $2.07 trillion). Defenders of Fed policy point out that is only half the story. Data from the St Louis Fed shows that the "monetary multiplier" has collapsed from a decade-average of 1.6 to the depths of 0.893. This means the 'velocity' of money has slowed to a crawl because those reserves are not making it into general circulation.

Apartently the banks are keeping that money in their reserves to keep themselves solvent. Without that money flowing, there can be no inflation.

And without the money flowing, the economy continues to contract. So the Fed continues to engage in 'quantitative easing' (the buying of bad debt) so that banks will gradually start to let money flow.

The problem, as Professor David Beckworth from Texas State University notes, is that the Fed's efforts to boost the money supply are barely keeping pace with the deflation shock. Stimulus is not gaining traction. The credit system remains broken.

"Where will the inflation impulse come from given that capacity use is at a post-war low of 68%c in the US, and nearer 60%c worldwide? The immediate threat is wage deflation", said Beckworth.

Tim Congdon – a hard-money Friedmanite from International Monetary Research – says the Fed is still not easing enough, perhaps because it is spooked by so much criticism or faces a mutiny by its own hawks. "If Ben Bernanke and his officials are listening to this sort of stuff and taking it seriously, they are making the same mistake as the Fed in the early 1930s," he said. The US 'output gap' is near 7%. That is a powerful lid on inflation.

Mr Congdon's prescription is what Britain did in 1931 and 1992: monetary stimulus à l'outrance (today: bond purchases), offset by spending cuts. This mix – easy money/tight fiscal – would halt debt deflation without ruining the public finances of the US, Britain, and Europe in the way that Keynesian schemes ruined Japan.

But here's the dilemma. The Fed buys their own US bonds to keep interest rates down.

If they don't buy them, the government's huge demand for credit drives up yields: greater supply of bonds leads to lower prices (and higher yields). Higher yields mean higher interest rates.

But if they do buy them, investors begin to fear inflation. Then, investors sell bonds... driving up yields: and less demand leads to lower prices (higher yields).

That's why the Fed is talking about 'keeping a lid on bond buys.' In doing so the Fed reassures investors.

The Fed is, in effect, also playing a giant confidence game with the money supply. Which brings us back to the topic of international confidence. The US enjoys a rare position as the world's reserve currency.

If that confidence erodes, the dollar could collapse and the US would be unable to finance it's debt without dramatically increasing the yields on it's bonds and treasuries.

The key people the US has to convince are the Chinese, Japanese and the Russians (the largest holders of US debt).

Last week we saw the Japanese and Russians come out and say they are one hundred percent behind the dollar and US bonds. The Japanese even say their faith is "unshakeable."

These comments helped send demand for bonds back up... after demand had dropped and yields on the 10-year note had reached 4% last week.

This, in turn, pushed yields (and interest rates) back down.

The Federal Reserve in the United States insists it can continue to walk this fine line with no problems. And when the economy does rebound, the extra money they created as stimulus funds can be withdrawn without those funds entering the general money supply (thus triggering inflation).

Not everyone believes that can be accomplished. Tomorrow we will hear from one of those doubters and why he thinks disaster looms on this colossal currency confidence game.

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Email: village_whisperer@live.ca
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