Fed Watch: Inching Closer to the Reality of Stagflation

Tim Duy assesses the Fed's options in light of the recent less than encouraging news on inflation and output:

Inching Closer to the Reality of Stagflation, by Tim Duy: There was virtually nothing pleasant about last week. At least, as far as the economy is concerned. The mass of data, the fresh instability in financial markets, and the latest testimony from Fed Chairman Ben Bernanke drove investors to the safety of US Treasury securities, all of which, at least at the short end, are yielding what must be negative expected real rates of return. Moreover, the odds now favor a 75bp cut at the FOMC meeting, a notch above the 50bp I am expecting. Not a surprise; the legacy of the past few months has been when you expect more, the Fed delivers. I am not ready to change my call at this juncture – I think it will be increasingly difficult for Bernanke to make the FOMC hawks choke down another big rate cut given the deteriorating inflation environment. And at some point, the Fed will need to hold their ground, or they will loose control of those anchored inflation expectations they claim to hold to dear.

The recent read on personal consumption and income starkly illustrates the Fed’s quandary- stagflation.  Inflation has brought a halt to real spending growth, even as nominal personal income growth continues to edge higher. And lest we forget, this is no longer just about headline inflation; the three-month annualized core-PCE rate is now up to 3%:

With still surging energy prices, including gasoline projected to hit the $4.00 mark this summer, this story looks set to continue. Consumer confidence, unsurprisingly, tumbles. And we can expect that confidence will deteriorate further; the solid push above the 350k mark for initial jobless claims suggests the labor market is about to take a turn for the worse, while recent reads on manufacturing point to a weak ISM report. The only pseudo-bright spot in the week was that new orders for nondefence, nonair capital goods continue to move sideways, avoiding the sharp drops usually associated with recessions.

Bernanke appears largely resilient to growing inflation worries; the risks to growth are what capture his imagination.  To compensate, Fed officials are pushing the story that they can quickly shift gears; market participants, by this logic, should expect policy symmetry.  From Chicago Fed President Charles Evans:

Now if we took out such insurance too liberally or too often, then private sector markets would change their views regarding policy and alter their base level of risk-taking. But in doing so, we likely would observe inflationary imbalances emerging or unusual volatility in output. So part of our job as a central bank is to properly price these insurance premiums against the achievement of maximum employment and price stability over the medium term. Importantly, when insurance proves to be no longer necessary, removing it promptly and recalibrating policy to appropriate levels will reiterate and reinforce our commitment to these fundamental policy goals.

In a perfect world, this is true. The Fed would have learned not to revisit past mistakes, such as failing to quickly withdraw the emergency rate cuts of 1998 or holding rates at 1% for too long. The world as it is, alas, is far from perfect. It is simply easier to lower than to raise rates. And I suspect this is especially the case this time around, as even if inflation pushes higher a tepid economic environment – the best that even Fed officials see emerging on the other side of this slowdown – makes meaningful rate increases politically difficult. And, as I argued last time, any rate increases are effectively off the table for the foreseeable future, as Bernanke cannot offset the fiscal stimulus he supported and largely designed.

It is increasingly obvious that the Fed is in a no-win situation. The best case scenario for the Fed is that nominal wage growth is kept in check by a deteriorating labor market. This will help contain inflation expectations and prevent a more serious 1970’s type of environment. But overall, Jim Hamilton is correct; they are unable to both contain inflation and prevent a significant economic downturn:

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

The nuance I would add to Hamilton’s position is that monetary policy – as well as fiscal policy – is faced with the additional problem of a fundamental imbalance between production and consumption in the US. The US consumes too much to the tune of 5-6% of GDP, relying on foreign production to deliver the excess. Global financial markets, credit, commodity, and currencies all included – increasingly find it difficult to sustain this imbalance. Brad Delong hit the nail on the head in 2004:

That's the thing about accounting identities like S - D - I = NX. Either you craft economic policies that make them hold at full employment, or the market takes care of making sure that they hold for you--but usually not at full employment. Stagnant or falling wages that boost corporate profits could boost savings S by boosting retained earnings. A Bush administration serious about cutting the deficit could provide financing for investment and keep interest rates from rising. Big booms abroad could raise U.S. exports and reduce investment as the Fed took steps to shrink investment to avoid inflationary overheating. Otherwise, it is indeed hard to argue with Barry just across the north wall of this office: the dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat.

The Fed is currently in the “then repeat” stage, although driving down the Dollar appears to have accelerated the surge in commodity prices, while the near term impact on export growth will be hindered by the need for structural adjustment (if only we could export vacant houses). At this point, more policy thrown at impeding this adjustment will only yield more inflation. This may not be a problem for Bernanke, however, who as late as last September took a benign view of these imbalances. This benign view gave him the freedom to attack the credit crunch regardless of the inflationary consequences.

The inflation, of course, serves a purpose – it is a market response to excessive consumption. Policymakers who want to pretend that the fundamental economic problem is insufficient demand rather than excessive demand will find the market yields a solution – higher inflation to depress consumption via declining real incomes and wealth.  Not a pretty solution, but a solution. Perhaps we are well past any other solution.

Bottom Line: I stick with the 50bp call because it is the most rational of the Fed’s likely options. 75bp, when the Fed knows they will have to deliver more, looks a little too risky given the inflation scenario and with the Dollar set for a new freefall. 25bp would simply be too much of a negative shock to deliver just weeks before the fiscal stimulus checks hit the mail. 25bp is not really likely; the debate is 50 or 75. Low real rates will eventually push investors out of Treasuries; I will leave it to the market strategists to tell you where the money will go.

Tim sends an update:

Update: Greg Ip at the Wall Street Journal also covers the stagflation story this morning. This passage, which I agree is an accurate assessment of Fed policy, is both enlightening and scary:

Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.

So far, they're still rising: wheat, oil and gold hit nominal records last week. But Fed officials don't think the latest jump can be justified by fundamental supply and demand. U.S. inventories of crude oil and gasoline are plentiful. Strong demand from China isn't new and should have been factored into prices long ago. A more likely explanation: investors, perhaps alarmed by the Fed's dovish stance, are pouring money into commodity funds and foreign currencies as a hedge against inflation.

Such fears can be self-fulfilling as higher food, energy and import costs work their way into consumer prices. But speculative price gains can't be sustained if the fundamentals don't support them. If the Fed and the futures markets are right, prices will be lower, not higher, a year from now.

The learning curve on Constitution Ave. is remarkably convoluted.  The Fed wasn’t willing to describe either the tech or the housing markets as a bubble since it is not their job to define fundamental values, but apparently is eager to define the “fundamental” value of commodities, and quick to dismiss current valuations as a bubble.

What is clear is that the Fed remains eager to dismiss any inconvenient information.  And, remarkably, a basic lesson that should have sunk in over the past decade is that even if you believe an asset bubble exists, it can continue for much longer than “fundamentals” would justify. Moreover, this piece reads as if there is no fundamental reason for the Dollar to be falling; instead, we are witnessing a bubble in all other currencies.  Yet if I pull any international finance book off my shelf, I am pretty sure I can find some reference that the “fundamental” value of a currency has something to do with interest rate differentials. Not to mention the yawning current account deficit.

I hope the Fed is correct, and I will be the first to admit error, but for now I am not willing to dismiss the signals commodity prices, or the Dollar, are sending.

Comments

[Managing Expectations]

"...eager to define the “fundamental” value of commodities, and quick to dismiss current valuations as a bubble."

This may be an effort to manage inflationary expectations. The Fed places heavy emphasis on using words to jawbone the market into thinking inflation will not be a problem. Nevertheless, investors seem to be voting with their feet (into commodities).

"The inflation, of course, serves a purpose – it is a market response to excessive consumption."

Workers/retired workers/savers cannot consume the same consumer goods that borrowers have already consumed. Someone must consume less, if subsidized borrowers consume more. The standard rinse and repeat for decades on end has been to transfer purchasing power from workers/retired workers/savers to borrowers. Only the rate of transfer varies. Since total consumption must fall due to foreign lack of interest in sending further goods on credit, workers/retired workers/savers must now consume less at a more rapid pace. Otherwise borrowers would have to consume less, which is politically unacceptable.

[esb]

A lot of words to express a simple sentiment ... we are in the hands of a con man, a grifter, a gamester.

Let's just lay things out the way that they are here ... we have just experienced an inflationary breakout. Each and every tier-one IB firm is on the same page with this conclusion, finally, and there is simply no way that a mountain of deceit, deception and duplicity from a group of hucksters with seats on the FOMC is going to be able to stuff this genie back into the bottle.

Benjamin "Zimbabwe" Bernanke (or "Z" as he is being referenced by some mid-level staffers at the ECB) has engendered a situation in which there is presently no realistic investable position available, other than to run from the currency over which he presides.

Which is why I say again, and not in any way lovingly, Mr. Bernanke, "get thee to an academy, to an academy, go."

Posthaste.

[ndd]

People are looking at the 1970s with its stagflation as the most apt economic allegory. I have put up a post elsewhere (g.o.s.) arguing with lots of long term interest rate and inflation graphs, that the correct decade is actually the 1940s. (look for the blog that starts "1946!").
The 1940s featured long-term interest rates of under 3%. Along with the 1970s, it is the only sustained period in the last 85 years that featured federal reserve interest rates, as well as long-term rates lower than the inflation rate.
The very lowest long-term interest rate since 1920 occurred in 1946. That very same year featured the very highest CPI reading since 1920 (~20%). Like today, interest rates were kept artificially low (then by WW2, now by FCB buying), and inflationary pressures were building (then, American wages; now natural resources and Chinese wages) . In 1946-7, the inflationary pressures briefly exploded -- even though interest rates remained low for several decades thereafter. Now, we see inflationary pressures similarly beginning to break through -- and I submit that like then, they must be brief -- now simply because America in particular will immediately go into a deep recession if the face of an inflationary breakthrough that will NOT be passed through into wages.

Submitted for the consideration of the very bright group here.

[hari]

This is a much more serious political development if stagflation is the end result of the rate cuts. Meanwhile it will impact the election like no other single indicator.
Obviously it will play into dems hands, if they know how to utilize the downturn implications to policy, and so on.

[anne]

I wonder why analytical account on account can be written on the economy with never a mention of the possible meaning of the fact that we are at war. At least argue that a trillion or 2 or 4 trillion dollar war makes no difference, but ignoring a possible economic effect of the war and the way we are financing the war makes little sense to me.

[anne]

Similarly, I wonder how much the emphasis on growing crops for fuel is raising food prices while having no significant effect on fuel prices. Joseph Stiglitz is in turn suggesting that a significant reason for fuel price increases. So, does war and the way in which war is finance have any economic effect? The silence by analysts would suggest "no."

[odograph]

Commodities do look like a bubble to me. And if this decade has been a flight from one asset to another (with increasing money supply), why not?

The increased money supply is going somewhere, if it isn't now heading to commodities, where is it heading?

I see the dollar as the flip side of that. As other articles have noted today, good US investments are drying up, leaving less reason to hold dollars.

[Mises]

5yr TIPS are now trading at -3 basis points.

[Greg]

Federal Reserve Chairmen don't have a bully pulpit with which to mold public opinion in order to execute public policy via fiscal, reglatory or other channels.

G W Bush is displaying yet again his incompetance for the office he holds. Thank good he's headed back to the farm.

The damage will still be great, but January 2009 we will have a Democratic Congress and (hopefully) a Democratic President to mend the fabric of American society.

[odograph]

Are TIPS for dumb money these days?

I'm afraid so. They are indexed to the wrong inflation (core), and hedonic adjustments are probably not appropriate in that setting.

[anne]

http://krugman.blogs.nytimes.com/2008/03/03/hair-of-the-dog/

March 3, 2008

Hair of the Dog
By Paul Krugman

One argument I’ve been hearing a lot lately runs as follows: “Low interest rates got us into this mess, so it’s crazy to think that low interest rates are the solution.”

Now, I don’t actually buy the first premise: I blame Greenspan for ignoring warnings about subprime and housing, but I still think keeping the Fed funds rate at 1% for a long time was justified by the economy’s weakness, which lasted until late 2003 or even beyond. But it’s true that we had an orgy of over-borrowing in the housing market. So the question remains: does an effort to encourage even more borrowing make sense?

Yes.

There’s an old joke that Jacob Frenkel, formerly of Chicago and then the Bank of Israel, used to tell to illustrate the fallacy of thinking that you always have to do the opposite of what caused the initial problem. A driver runs over a pedestrian; he looks back, realizes what he’s done. “I’m so sorry,” he says. “Let me fix the damage.” So he backs up, running over the pedestrian a second time.

What we have now is a spending slump. It’s the consequence of easy credit that led to reckless spending in the past — but the problem now is how to sustain spending; trying to encourage austerity at this point will just make things even worse. Keep cutting, Ben!

[anne]

"Are TIPS for dumb money these days?"

The Vanguard inflation protected securities fund is up about 5.3% so far this year. Say what?

[robertdfeinman]

The western financial markets are in the midst of a panic. When there is a panic all rational behavior ceases and the mob takes over.

I got a notice that one of my CD's is coming due so I decided to check on bank rates. Typical rates seem to be 3% or less, which means that the real yield is negative. Loan rates to consumers haven't come down so the spread may mean either that banks don't want new deposits because there is no one to lend them to, or they are cheaply refilling their coffers and they will show improved earnings by year end.

I have my own barometer it's high quality preferred stock. A typical example is this one from GE - ticker GED: It is selling for about $24.40 for a $25 face and has a current yield of 6%. It's price has been essentially unchanged throughout the latest turbulent period.

So while the mob is rushing to "safety" someone is getting a nice return on a preferred from a firm which is under no foreseeable financial strain. Three or four years from now we will see the articles which say "if you had only bought xxx at the height of the panic you would have a 20% profit now".

Comparisons with 1929 (which many commentators imply even if they don't say so explicitly) are inappropriate. In 1929 the world was still on the gold standard, the concept of cooperating central banks didn't exist, there were no safety nets for individuals and the ton of money which is sloshing around in the second world hadn't been created yet.

When prices get cheap enough in the first world this money will move into the west and the trickle of purchases of financial assets will become a flood, putting a floor on the devaluation of financial firms.

The inflation will still hurt the working class, especially since there is no longer an effective organized labor movement to fight for compensating wage increases.

[Winslow R.]

ndd wrote :"Now, we see inflationary pressures similarly beginning to break through -- and I submit that like then, they must be brief -- now simply because America in particular will immediately go into a deep recession if the face of an inflationary breakthrough that will NOT be passed through into wages."

Inflationary pressures without rising wages are leading to a falling standard of living here in America. As long as we can still get to work (on our reduced incomes) so that we can produce more goods and services to be exported, a recession is not a foregone conclusion. The reduction in living standards could go on for a while. I still see people driving Hummers.

Ben seems content to push Americans in the direction of reduced living standards. McCain leads in most polls. The American public is okay with the present course?

[anne]

http://www.nytimes.com/2008/03/03/opinion/03mon1.html?ref=opinion

March 3, 2008

Priced Out of the Market

The world's food situation is bleak, and shortsighted policies in the United States and other wealthy countries — which are diverting crops to environmentally dubious biofuels — bear much of the blame.

According to the United Nations Food and Agriculture Organization, the price of wheat is more than 80 percent higher than a year ago, and corn prices are up by a quarter. Global cereal stocks have fallen to their lowest level since 1982.

As usual, the brunt is falling disproportionately on the poor. The F.A.O. estimates that the cereal import bill of the neediest countries will increase by a third for the second year in a row. Prices have gone so high that the World Food Program, which aims to feed 73 million people this year, said it might have to reduce rations or the number of people it will help.

The world has faced periodic bouts when it looked as if population growth would outstrip the food supply. Each time, food production has grown to meet demand. This time it might not be so easy.

Population growth and economic progress are part of the problem. Consumption of meat and other high-quality foods —mainly in China and India— has boosted demand for grain for animal feed. Poor harvests due to bad weather in this country and elsewhere have contributed. High energy prices are adding to the pressures.

Yet the most important reason for the price shock is the rich world's subsidized appetite for biofuels. In the United States, 14 percent of the corn crop was used to produce ethanol in 2006 — a share expected to reach 30 percent by 2010. This is also cutting into production of staples like soybeans, as farmers take advantage of generous subsidies and switch crops to corn for fuel.

The benefits of this strategy are dubious....

[anne]

Are analysts willing to discuss either war and the financing of wear or the policy of growing crops for fuel as having economic significance, beyond that is having the Financial Times use an Assistant Managing Editor of the Wall Street Journal * to deny that war have any cost whatsoever since war has no exact cost?

* The FT even took pains not to identify the analyst as a WSJ editor.

http://www.ft.com/cms/s/07d4beda-e8c3-11dc-913a-0000779fd2ac,dwp_uuid=ebe33f66-57aa-11dc-8c65-0000779fd2ac,print=yes.html

[anne]

Joseph Stiglitz has been arguing that a wildly costly war financed wholly though borrowing, as no other American war, is having a significant effect on the economy. Are other analysts even willing to discuss the matter? Why is war treate as of no economic consequence so often?

Paul Krugman has raised the matter of policy designed to grow corn for fuel, but this too is seemingly ignored by analysts discussing inflation prospects.

[odograph]

Here's the dumb money article.

I don't understand this, I am dumb and risk-adverse money, so I don't even know how rising fund prices relate to their long-term worth.

[kthomas]

I like Winslow's Hummer observation. I can't stand those ugly things.

[kthomas]

anne, I regret saying this, but there will be no open discussion of the fighting (or financing of) in Iraq until there's a draft, and probably a corresponding increase in taxes to support the war. And those things are NEVER discussed.

[billy]

Hoarding food is a better investment than hoarding money now. So what's surprising in speculation in commodities?

First the bubble was in stocks. It did not have a material effect on bystanders

Next it was in housing. Bystanders had minor inconveniences, like renting, moving etc.

Now it is in food. Bystanders -some - will suffer hunger.

And sure as night follows day, that is going to lead to the game with the highest stakes - war. Bystanders pay with their lives.

As certain as Germany's outcome on the WWI reparations, the bubble policy of the Fed will certainly kill. Then Keynes was there as a prophet; today all economists sing Hosannas to the atrocious Fed policy.

[Mises]

In a crack up boom commodities eventually selloff relative to Gold. I would recommend that anyone looking to hedge against inflation not to buy non-Gold commodities. Gold always gets a significant premium when monetary systems collapse.

Buy Gold and no other commodity. You have been warned.

[lonesome_moderate]

We have had seven years of a presidency with virtually no policy mechanism--just politics driving everything. If we get out of this with nothing worse than a mild recession and a couple of years of staglfation, then Bernanke will have brought off something like a miracle.

[Gerard MacDonell]

Actually, the link from the current account deficit to the domestic price of U.S. capital assets was one of the big misses by the big international institutions and liberal academics like Brad Delong. It was obvious back in 2003 that the current account balance was on an unsustainable trajectory and that a substantially weaker dollar would result from the required turn. It was also obvious, via the accounting identity you cite, that this would require a rise of national savings relative to investment.

But contary to the confidently and wrongly asserted claims of the time, it was never clear what affect this rebalancing would have real interest rates here in the USA. If the rebalancing were imposed from abroad, then yes real rates would have to rise. But in the event, what actually happened is that the domestic sectors wanted to move towards balance more quickly than the foreign sector did. So the rebalancing involved LOWER interest rates and a lower dollar.

To miss this ex-ante was a big but understandable mistake, as the recent experience here in the USA has been somewhat unique in the history of external adjustments.
But to deny it ex post is very hard to understand. What is up please?

[Callahan]

Bush was/is an Abomination bringing Stagflation, now it is time to undo Socialism for the rich, yes it is time for an Obama-Nation.

[flow5]

Stagflation results from various things.

As long as the U.S. continues to run current account deficits, these deficits will inexorable force the dollar down in terms of its foreign exchange value – and no consortium of central bankers, treasury secretaries, et al. can stop the process.

These deficits are primarily the consequence of (1) a non-competitive economy – the U.S. needs to sell higher quality, lower cost, goods & services, (2) our dependence on imported oil, and (3) the Pentagon’s unilateral transfers to foreigners.

We are now currently selling our birthright for a mess of pottage. We are a financial hostage to the Pacific Rim, the oil exporting countries, etc.

Unless we are willing to make those fundamental reforms requisite to successfully competing in international markets, the continued decline of the dollar will finally force a payments balance on us.

From these unwanted events we can expect a vicious level of stagflation that will become an enduring feature of our economic landscape. And we can expect long term deterioration in the standard of living of the vast majority of the people in this country. The United States will be most likely be forced into a high degree of economic isolation, be required to operate under a command economy and drift into an increasingly totalitarian mold.

[flow5]

A flight from the U.S. dollar will result in some degree of hyperinflation in terms of dollar denominated assets.

[btg]

frankly, i think the idea that the current economic crisis is one of "stagflation" is a little overdone.

see http://www.inflationdata.com/Inflation/images/charts/Articles/Decade_inflation_chart.htm

long term inflation from 1913 to 2006 averaged 3.43% - so current rates of inflation are above the long term average. frankly, the low inflation of the last 20 years has had the effect of permanently distortion perceptions about the so-called evils of inflation. inflation in the 1970s average 7.09% - if the fed would print money, instead of effectively borrowing it from china (which keeps the dollar higher than it should be) and inflation were to go to 7% or more, the economy slowdown and housing price deflation would ease and the economy would recover.

inflation is usually cited as being a problem because of negative real inflation rates, the loss of value to bondholders, and the impact to people on fixed incomes - problems that are overstated. low inflation and low nominal interest rates (with high real rates of interest) benefit those who already have piles of cash to invest.

in the 70s, inflation was bad because of structural reasons - an inflationary spiral because of cost of living adjustments in union contracts, and the wage inflation drove or sustained the spiral, all validated by monetary policy. this no longer exists - inflation today is driven by the decline of the dollar and higher commodity prices because of economic growth outside if the US

the other thing here is that the US has to force China to let its currency appreciate faster - and to unlink it from the dollar, at the very least, by switching the peg to a basket of currencies.