The Fed Desperately Seeking Inflation

To nobody's surprise, at its meeting today the Fed kept short term interest rates where they are. After all, the slumping economy sags anew with each passing quarter. The Fed also fired a shot across the bow of bond market bears, pledging to use the proceeds of its maturing agency (meaning Fannie and Freddie) debt and mortgage-backed debt to purchase longer term U.S. Treasury securities. This latter measure is tantamount to monetizing federal debt--in other words, printing money for the federal government to spend.

Recall that last year, the Fed bought a shipload of mortgage-related debt in order to loosen up the mortgage market. This pumped a lot of money into the financial system (in effect, providing funds for new mortgage loans). The Fed didn't have the money it used. It simply printed it. We're talking hundreds of billions of dollars of printed money; maybe over a trillion. What the Fed now proposes to do is reinvest repayments of the mortgage-related debt in longer term Treasury debt. That keeps the printed money out in the financial system, perhaps for many years.

Printing money can cause inflation. The Fed believes that a dab of inflation adds a fillip to the economy, allowing businesses to raise prices more easily and debtors to repay creditors with cheaper dollars, thus spurring growth. The Fed has been seeking inflation, with cheap money policies and publicly announced inflation targets. But prices haven't cooperated. While they're still rising, the rate of increase is around 1% a year, the lowest in a half a century. The Fed would like to see 2% or a tad more.

By purchasing Treasuries, the Fed keeps the pressure on longer term interest rates and may push them down. In normal circumstances, lower rates would probably spur growth. But the process of deleveraging from the profligates' ball of the 2000s seems to be getting in the way. Banks don't want to lend, because they still have skeletons in their closets and are holding back cash to cover their butts. The creditworthy aren't borrowing because they're trying to pay down debt, not take on new loans. The uncreditworthy are being denied credit, for the first time in more than a decade but all parties run out of punch eventually. The days when a signature and a pulse could command hundreds of thousands of dollars of credit are over. So lowering long term rates won't be likely to have much stimulative effect. It will only reduce the federal government's interest expenses.

One wonders if that isn't something the Fed intends. There's no way for the federal government to quickly reduce its deficit by a meaningful amount. It will be borrowing a shipload of money as far as the eye can see. By keeping the federal government's borrowing costs low, the Fed prevents even more borrowing by the Federal government to cover rising interest expenses.

In addition, when the Fed uses some of the printed money from maturing mortgage-related debt to buy Treasuries, it's reducing the amount of "real" dollars the federal government has to borrow from holders of capital. That reduces the competition between the government and the private sector for credit. As much as Ben Bernanke jawbones the government to restrain spending, he's making it easier to run federal deficits. Lower prices spur consumption--that's Econ 101. Lower the price of government borrowing and the government will borrow more.

Best of all, printing money is a time honored way for governments to spawn inflation. By investing in longer term Treasuries, the Fed is saying it will keep those printed dollars out in the financial system potentially for a long time, where they might fluff up the price structure.

Or not. The deleveraging process in effect reduces the money supply. That's because a loan increases the velocity of money, which in effect expands the money supply. Paying down debt reverses the process. As our debt besotted society tries to sober up, the Fed's monetization of federal debt may simply offset some of the private sector debt shrinkage. The net impact may be little or none. This could be what's happening in Japan, where the private sector has gone through a gargantuan deleveraging from the mother of all credit expansions in the 1980s. Government debt in Japan runs 200% of GDP (America's is around 65%-70%), but inflation is almost non-existent. The economy is stagnant. Government leverage seems to have taken the place of private leverage, but on a net basis not much has changed.

So the Fed's monetization of debt, at least at the prospective levels indicated by today's announcement, may not spur inflation. And even if it did, there's no guarantee things will improve. Throwing a lot of cash out the door of the Federal Reserve System (directly or indirectly into the hands of the federal government) won't necessarily do anything to bolster the real economy. The cash has to be spent the right way, increasing investment in productive activity--meaning the production of goods and services that people want to buy--not more subsidies for banks that hoard cash that is invested in U.S. Treasury debt. To be valuable, money has to be spent wisely. There's no requirement for wisdom attached to the printed money the Fed is pushing off its loading dock.

The Federal Reserve's Gamble with Inflation Policy

The Federal Reserve's policy on inflation appears to be the hope that an economic slowdown will restrain price increases. Yet the Fed is doing everything it can, including the use of kitchen sink policies that it created on the back of an envelope, to prevent a recession. If the Fed is successful in accelerating the economy, it won't get the restraint on inflation that a slowdown presumably would have brought. In such a situation, it may have to raise interest rates rapidly to tamp down inflation. But rapid rate increases could undo the Fed's stimulus, sending the economy into a tailspin.

We have recently gotten some stern lessons about trying to be too clever by half. That's how the big banks in the derivatives markets managed to offload risk and send it on a circular path back to their own balance sheets. The derivatives markets are so complex and opaque that the banks didn't realize the horse they were buying was the same toothless nag they had sold last week.

Inflation is rising worldwide, with oil and food prices leading the way. In some nations, we're seeing a revival of old-fashioned food riots, the developing world's equivalent of a run on the bank. The nations that manufacture the goods sold in American stores are struggling with rising costs and are passing them onto the American consumer. Higher shipping and transportation costs add to the prices of manufactured goods. Foreign central banks are keeping interest rates comparatively high to combat inflation, thus protecting their own currencies at the expense of the dollar. The weakening of the dollar increases the cost of imported goods. This worldwide flurry of price pressures will pop a lot of holes in the dam that the Fed is trying to hold back.

Fundamental to the Fed's inflation policy is the premise that an economic slowdown will reduce purchasing power to the point where it discourages price increases. But let's remember where today's purchasing power comes from. Employment is only part of the picture. For many people, credit is the principal source of purchasing power. Employment can be the beginning point for an extension of credit. But the amount of purchasing power one gets from a credit card may be multiples of one's monthly income. (Compare your monthly aftertax income to the combined lines of credit on your credit cards, and you'll see what we mean.) Even if incomes are constrained by an economic slowdown, price increases can be absorbed by greater use of credit. Many banks are cutting back on the amount of home equity lines of credit. But borrowers can simply turn to their credit cards. Even if these are more costly, the low monthly payments required on credit cards mask and soften the real costs.

Thus, the oceans of credit available to the American consumer allow price increases to stick even as the economy slows. People will reduce big expenditures, such as the next car, a new and fancier refrigerator, or a home remodeling project. But they will, with some grumbling, be able to absorb the increased prices of bread, milk, gasoline, heating oil, natural gas, airline tickets and so on. Easy credit facilitates stagflation. When banks can borrow from the Fed at bargain basement rates and relend to credit card borrowers at rates sometimes approaching 20% or more, they enjoy a nice profit. They won't cut back on their profitable lines of business.

Things are nowhere nearly as bad as the stagflation hell of 1979. But that's not the relevant comparison. The appropriate analogy is to 1973-75, the beginning of the era of stagflation, when the first OPEC oil price hikes were followed by a faltering economy, a falling stock market and increased inflation. The Fed focused on stimulating the economy, keeping interest rates relatively low. The stock market revived, but only temporarily. By believing too much that inflation and recession are mutually exclusive, the Fed wound up having both to contend with. The painful resolution came five long years later, when Paul Volcker replaced Arthur Burns as Fed chairman and decided that the only way to true economic health was to suppress inflation by sharply raising interest rates, knowing that it would throw the economy into a nasty recession. That was the right decision, but it probably resulted in more pain than would have been suffered had his predecessor made the same choice five years earlier.

The Fed's current policy is to believe that we can have it all, even though its restraint on inflation is the slowing economy that it is trying to prevent. This may be plausible to those who believe up to six impossible things before breakfast. But some--call us the skeptics--tend to think that the Fed is rolling the dice for a hard eight (a Las Vegas term for the dice turning up four and four). This play might have a generous payoff. But the chances of winning are low and we, the people, will pay the price if the government is wrong.