Federal Reserve chairman Ben Bernanke confirmed Friday the central bank is ready to open the liquidity hydrants once more, saying there is “a case for further action” to provide more monetary stimulus because “inflation is too low.”
But the Fed chairman’s comments this morning in a speech before the Boston Federal Reserve have ignited heated debate on Wall Street as to whether the central bank has accurately diagnosed the US economy’s problems -- whether it faces deflation, disinflation in extremis, inflation, or hyperinflation.
And also whether the central bank’s fire hose of liquidity is the right cure.
Fed officials have aimed to keep inflation in a range of 1.7% to 2%, and inflation has been hovering in and around the lower end of that range.
Fed chair Bernanke has been warning about deflation since 2002, and in turn deflation tautologies at the Fed have not only taken hold, but have now hastened more monetary intervention, with Wall Street economists fearing the moves will increase the odds of hyperinflation.
Societe Generale's Albert Edwards said "the coming deflationary maelstrom will be additional money printing that will make the recent QE seem insignificant."
Inflation is typically defined as too much money chasing too few goods, with hyperinflation being the extreme Weimar Republic or Zimbabwe examples. Disinflation is a decrease in the rate of inflation (My vote).
But deflation is defined as a decrease in the general price level of goods and services, and is widely feared by central bankers the world over, because it locks economies into a downward spiral, is adhesively sticky, and is difficult to fight.
Once consumers and businesses believe deflation is upon them, they do not want to make purchases or take on debt, believing prices and profits will continue to fall. Already, the US economy is struggling with excess capacity and a lack of demand, as consumers and businesses continue to de-leverage. And businesses have deployed technology to step up productivity efficiencies, which require fewer workers, which has also kept inflation low.
The thinking is, by hiking expectations of inflation, businesses and consumers will start to buy now, before prices increase. And since a devalued dollar would arise, that may encourage even more borrowing, since existing loans would be paid off later with more dollars.
To rescue the economy, the Fed has already kept the federal funds rate (the overnight rate banks charge each other for loans) to between zero and 0.25%. It has also purchased $1.7 trillion of Treasuries and mortgage-backed securities in a bid to drive Treasury yields lower, which would then push borrowing rates lower, as those rates are typically tied to the 10-year note.
The Fed chair said the central bank is “revisiting monetary policy in a low-inflation environment,” is prepared to provide additional accommodation if needed,” that "there would appear...to be a case for further action.”
But Fed chair Bernanke said the central bank will "proceed with some caution,” signaling further purchases of securities will come in installments, and not all at once. Wall Street widely expects the US central bank to begin a new program of buying longer-term US Treasury securities at its Nov. 2-3 meeting. Investment houses, including Goldman Sachs (NYSE:GS), say Treasury purchases could total $1 trillion, with others saying $500 billion. The expectation is that the Fed will rotate out of its existing mortgage-backed securities into Treasuries.
Reports indicate that internal Fed models suggest such added purchases could knock anywhere from 0.15% to 0.20% off the 10-year Treasury yield, hopefully dropping mortgage rates as well.
Barclays Capital notes yields on 10-year Treasuries have dropped 50 basis points within a month on expectations of more Fed stimulus.
But likely the most controversial statements Fed chairman Bernanke made are these: That 1% inflation is "too low,” and that the risk of deflation is "higher than desirable.”
Despite the central bank's purchases of about $1.7 trillion of Treasury debt, as well as Fannie Mae and Freddie Mac debt, imputed M3 -- which is a key measure of money, meaning credit supply -- has still been on a downward trajectory.
But the thinking is, once that money, on top of the expected extra round of QE, is unleashed in the markets, you will see a flood of money chasing too few goods, which is inflation. And due to the gunning of the printing presses, the dollar has already dropped to its lowest watermark this year against a broad basket of currencies. It hit 15-year lows versus the yen, and is reaching parity with the Canadian loonie.
In turn, so far in 2010 the price of crude oil has jumped by 27%, of corn by 63%, of wheat by 84%, of sugar by 55%, and of soybeans by 24%, notes Art Cashin, director of floor operations at UBS Financial Services.
Cashin also says that holding gold would have yielded 34% in less than a year, holding a Treasury note would have yielded a nominal 1%.
Peter Boockvar, equity strategist at Miller Tabak, remains staunchly opposed to the Fed’s policy decisions and says the US economy is far from a deflationary environment, given that commodity prices, rental costs, health care costs, and college tuition costs continue to rise.
"Deflation is defined as a decrease in the general price level of goods and services; but..the CPI [consumer price index, a measure of inflation], has fallen just 1% from its all time high” in the early ‘80s, he says.
“Policy makers think we should raise the cost of goods and services in order to cure a lack of demand,” Boockvar says. But that’s wrong, he adds.
Instead, “the law of supply and demand says lower demand must be met by lower prices in order to get to the proper equilibrium,” Boockvar says -- prices dictated by the market, not the Fed.
"What the Fed really wants to do is create inflation in order to not deal with an overleveraged economy in the most responsible way, either paying debt off or writing it down. They want us to pay off the debts with inflation,” Boockvar says.
And UBS economist Paul Donovan issued a report earlier this year attacking the notion prevalent in the Keynesian world that governments can simply inflate away their debt, as they have done in the past.
“It does not work, absent episodes of hyper-inflation, it has never worked,” he says.
Why? The shorter duration of government debt means investors will demand higher yields if they see inflation arising, which means more money spent on just interest on the US debt, Donovan says.
The US is expected to roll over almost 45% of its debt in the next year, 55% in the next two.
“Unless a government is willing to pursue hyper-inflation as a strategy, raising inflation will not reduce the government debt burden,” Donovan says.
Indeed, history indicates that the reverse result will be achieved, he says. “The higher debt service cost becomes a problem for a government that is pursuing an inflation strategy because government debt does have to be rolled over.”
Street analysts also say stimulus moves by the Fed and Treasury are sparking fears of an international currency war, with Asia seeing a flood of money into its markets, causing concerns about asset bubbles there. Concerns are growing that countries could retaliate with a series of competing devaluations, or tariffs on US-made products.
Moreover, the bond vigilantes have kept quiet, but some economists say not for long, as governments the world over have been issuing debt to pay for their own recoveries, meaning lots of bonds competing with each other for a finite number of investors, causing them to offer ever higher yields, and leading to a bond market crackup.
“This could all end very badly for the bond market,” says economist Ed Yardeni. “Imagine the Fed trying to unload lots of bonds in response to better-than-expected economic growth combined with higher-than-expected inflation.”
Yardeni says: “In this scenario, it isn’t hard to imagine that the 10-year Treasury yield could rebound from let’s say 2% to 4% very quickly. If that were to happen, then we will have an affirmative answer to the question whether the Fed caused a bubble in the bond market.”
And some Wall Street analysts say that could start to happen in the next couple of years.