Thursday, October 21, 2010

The eight hundred pound gorilla meets the weight of evidence

The eight hundred pound gorilla meets the weight of evidence

As we see it the Fed is overly fixated on the risk of deflation. Partly the Fed argues that deflation is such a terrible thing, policy needs to ensure it does not take hold. But what is deflation? Is it having the CPI drop for one month? Is it a drop in the headline or in the core? How long or severe does the drop in some key price index need to be for it to be construed as deflation instead of just low inflation with some normal volatility? It’s not as though having some CPI measure negative for one month is going to inject the economy with some fatal disease. I wish the Fed would specify its fear. It has drawn a line on inflation as have other central banks then gone above it. But what about deflation and the number zero? Is it inviolable? What is the trip-wire for the deflation trap?

We know the fear: Japan. But is this ‘Japan’? Is our currency being pushed up accentuating the deflation as it was with Japan? Are stock prices super high and are P/E ratios on the moon? Is all of real estate so wildly overvalued that a long period of adjustment lies ahead? Are residential house prices so high that we need multi-generational mortgages to make buying them at current prices feasible for families? During its most troubled times Japan also had a high debt to GDP ratio. And while we are beginning to worry about our debt ratio, it is nothing like Japan’s. The dollar is weak, not strong. Houses are very affordable, not too-expensive. Stocks are reasonably priced. The parallels with Japan are not strong at all. Still, there is more than one way to enter deflation. Are we just going through a different door?

Disconnect number one: Indeed, the most consistently negative aspect of the US economy has been the amazing tendency for policymakers to see bad news everywhere. These are people with a vested interest in telling you that things are BETTER THAN THEY SEEM! We know the importance of expectations in economics. So why was the President so late in seeing recovery? Why did he deny it after the first good GDP number which, as it turns out, did herald the start of recovery? We know why. It was to gain political advantage and blame the Republicans as long as possible. Political infighting is one main reason why we are not in a better recovery right now. Being pessimistic is seen as being prudent. How did that happen?

And what of the Fed? It seems to be overly concerned about a very mild drop off of core inflation. With the dollar falling and commodity prices so high, is that fear rational?

Disconnect number 2: Interestingly - at least it seems to me - conservatives have become the bulls and liberals the bears on the economy. The liberals (Democrats) want the Fed to do more. The conservatives (Republicans and free market types) do not want the Fed to do more. Politicians of both stripes want the Fed to do something because they do not want to do anything! In taking steps, they risk the ire of the electorate that is worried about the build-up in debt, making new fiscal stimulus tough to get without alienating voters. So our ‘leaders’ have stepped forward by taking a step back –and for that they want to be re-elected?

The sparking short-circuit - The 800 pound gorilla in the room that everyone is ignoring is the fact that if the Fed stimulates an economy that does not need it and if recovery comes, and subsequently overheats, the signals in place from commodity prices gold and money growth will make the Fed’s error look especially foolish. Free-market economists line up, looking at these traditional inflation indicators, wanting the Fed to stay on the sidelines while these signals are flashing. Keynesian economists look in another direction, at the huge GDP gap (short-fall of actual GDP from potential), and feel it will be an inevitable source of further deflationary pressures. So, are we all Keynesians now? Or are we just afraid of being Japanese? And do either of these fears have merit?

The graphs above (graphs are in the blog version of this report email me if want to see them, regrets) look at the core inflation rate and the services sector less the controversial rent of shelter portion and less energy. What we see are broadly mild trends.There are volatile herky-jerky moves on 3-mo growth rates but for the two main components of the core (goods and services) the picture shows infation is still mostly steady and moving sideways even over 3-Mo. For a central bank that talks of inflation being capped at 2% (and 2% is the cap rate that other inflation-targetting central banks use and its one that the Fed had talked about- it has no formal ‘target’) these previaling 3-Mo rates are inflation rates closer to the middle of the range (2% to zero %). The special service category with the rate of change compressed to its three-month horizon shows more distress but also more volatility. We insert that one to stack the deck in the Fed’s favor.And even that one is not compelling. Sure you can wring your hands about this, but is this really creeping deflation?

The upshot is that the parallels with Japan are not as strong as the fears and mutterings of the pundits. The politicians – pick your party, any party- are spineless wimps. They are dumping the case for action in a lap where it does not belong- the Fed’s. The Fed is not as powerful OR as independent as it was once. It was severely criticized for its role in the financial crisis and had to lobby Congress to retain its powers. It is more dependent on Congress and this administration than ever before. And, yes, it has made mistakes but it also acted when the politicians moved to the sidelines in the crises. The Fed bore a load then that it probably should not have; making it bear this one is wrong too.

More monetary stimulus is not the answer. Jobs are the problem. The links from monetary policy to job growth when you have a liquidity trap, as we seem to have, are as strong as a third grader’s construction paper and glue chain link project. The employment problem needs a different fiscal solution. Helicopter Ben can’t solve it. And the ‘threat of deflation’ does not need the Fed’s hand.

It’s not that banks don’t have problems or that the Fed has no role. The new foreclosure imbroglio could be another swat to the backside of the banks. Some think the new push for QE has this risk as its motivator and believe that the Fed will buy up more mortgages to ‘paper over’ the issue. Banks are facing stiffer regulation. And then there is the fact that lower rates do not make them want to lend more, so how is that a solution? Banks are being told that they have to hold more capital and so they want to risk less but everyone is being urged to see MORE risk in this economy. What a comedy of errors! Lending early in a recovery is supposed to be safer since the economy is expanding. Instead, of lending on the expected recovery trajectory banks are not-lending because of the continued risk ‘of deflation,’ slow growth, the potential for backsliding and the large GDP GAP. Is the belief in Keynesian economics holding us back?

From ‘the Big Picture’ to the ‘Bigger Picture’

Is the economy gaining a toe-hold and moving ahead? Is there anything to this fear of backsliding? How did this great economy lose its mojo? We have gone from a nation of rugged individualists to a pampered group of government-aided stay-at-home shut-ins with leaders that urge the over-burdened central bank to carry more of their load instead of making tough decisions themselves. No wonder people are placing bets on China this millennium. If this is an example of what we have become, we are doomed. It’s no wonder either that the Madhatter is spreading his tea party.

Do we still have a spark of entrepreneurship? Are there, not just risk-takers, but any who are not afraid of their own shadow? Can anyone see how dysfunctional our political system has become? Who would bell this cat? How can we get rid of a thing like the electoral college that gives Republicans and Democrats a tight grip on national politics? Why is it popular for our nation to bail out our banks but not to help our people? In comparison concerns about monetary policy-making this cycle pale in importance. Still…

Is Bernanke blinded from seeing the real risk and is he going to be caught in the clutches of the 800 pound gorilla because he is looking at the risks in his rear view mirror, risks that he has studied for so long? And if he makes the BIG MISTAKE all of the above problems will probably be made worse.

Cross roads or double-cross roads? You can almost sense that America is at a cross roads. As at other times in her past this crossroads has come with a huge influx of immigrants, some legal, some not. We are facing a new appraisal of our values. What will government provide for its people? If we have hit the debt limit (debt-to-GDP?) it means we have hit the peak of redistributive policy unless an even more redistributive tax policy is put in place. We are only beginning to see what happens when you increase burdens on the most productive.

It has been easy for politicians to spend more and to dole out benefits when no one paid anything but more interest on the national debt. Now if they have to fund redistribution in real time with real money the tensions will become more acute. We will have our class warfare. If government pulls back on benefits like social security and medical care, as seems inevitable, tensions and vitriol will rise. And as government considers these options we see how poorly the economy operates when these public policies and burdens are shunted off onto private enterprise as we ‘pretend’ that we do not have to pay for them. All polices have costs. Chinese companies offer no health care to their employees. American firms compete with them. US firms have a relatively recently raised minimum wage. China does not have one. And so on.

So we draw the line. But where? And on which side of it will you stand? Most important of all, who will draw it?