THE BEAR'S LAIR
A few weeks ago, I compared Federal Reserve chairman Ben Bernanke to the Weimar Republic central banker Rudolf von Havenstein. The comparison looks even better after the Fed's non-performance on April 27 and the markets' subsequent response.
Even the more cautious members of the general media are beginning to compare the current outlook to that of the 1970s, and making jokes about leisure suits and disco. However, neither Bernanke, who appears in denial, nor the media as a whole has focused on one huge flaw in this comparison: there is no known economic law that will make inflation arrest its surge docilely at 10%, as it did twice in the 1970s.
There appear to be two possible trajectories. On the one hand, Bernanke may be right and the rise in global commodities andenergy prices may be temporary (but this has other unpleasant implications, as I will get to shortly). On the other hand, if the current trajectory of commodities prices, energy prices and price levels in general continues beyond the end of the year, then by early 2012 it is likely that prices will be rising much more rapidly than in the 1970s, with the Fed panting helplessly in pursuit.
The middle trajectory, that of the 1970s, when as in 1974 and 1980 inflation rose fairly slowly to around 10% or just above and then retreats, appears very unlikely. In both 1974 and 1980, interest rates were pushed above the inflation rate, mildly so in 1974, severely so in early 1980 and in 1981-82. The result was a retreat of inflation, partial and temporary in 1975, major and long-term in the 1980s.
Inflation at the producer price index and the imported goods level is already running at 10%; however, interest rates remain at zero and are not going to move for an "extended period” - defined by Bernanke on April 27 as meaning at least two Fed meetings - so at present not before September.
Given his reluctance to raise interest rates, it is inconceivable that even when he moves Bernanke will raise rates hurriedly. If he follows his 2004-06 trajectory of raising by 0.25% at each Fed meeting, he will not get to a 10% Federal Funds rate until August 2016. Even if he moves somewhat faster than this, mixing his 0.25% raises with the occasional 0.5% or even 1% raise, interest rates will remain far below the rising level of inflation.
Thus monetary policy will continue to accelerate inflation increases rather than retarding them, making the trajectory of an inflationary move to around 10% not merely unlikely but impossible - when it gets to that level, there will be nothing holding it back, but a considerable force propelling it higher.
Bernanke's forecast, that commodity and energy prices will fall back of their own accord, is not as misguided as many of his predictions. After all, commodity and energy prices did just that in 2008, much to the surprise of both forecasters and the markets - several mining sector bankruptcies resulted.
What's more, it did not require a sharp increase in interest rates for commodities and energy prices to collapse; they did so while real interest rates were substantially negative - Bernanke had already been lowering nominal federal funds rates nearly to zero after their peak at a modest 5.25% in 2006-7. However, in order for the commodity price reversal to occur, it required the worst global banking crisis since at least 1974 and its deepest recession since World War II.
That illustrates the problem with this prediction. If interest rates were to increase substantially above the rate of inflation, as they did in 1980, then commodities and energy prices would eventually deflate, possibly at the cost of only a moderate recession, as in 1980-82. Oil prices at that time, for example, declined only modestly; their real collapse came only in 1985-86.
However, high real interest rates are a sufficient but not necessary condition for commodities and energy prices to collapse. If Bernanke keeps short-term interest rates at zero, and commodities and energy prices continue to inflate, then at some point the bubble may burst of its own accord. The dot-com bubble burst in 2000, after all, as did the South Sea Bubble in 1720.
The problem is that the trigger for the bubble bursting, if it is not to be higher interest rates, can only be a collapse in demand. If oil prices rose to US$300 per barrel, for example, the United States as a consumer of oil would lurch into a major recession, like that of 1973-74 but deeper, as consumer purchasing power for non-oil products collapsed. That is essentially what happened in 2008. That major recession would then cause a collapse in world trade, as happened in late 2008 and knock-on recessions in the major supplying countries of China and India (which would themselves be pushed towards recession by the increase in commodity and energy prices).
Thus if as in 2008 commodity and energy prices race far ahead of retail prices, so that purchasing power collapses, Bernanke is likely to be right; commodity and energy prices could collapse without inflation ever really taking off. All it would take is a re-run of something uncomfortably close to the Great Depression. A collapse in the Treasury bond market, very possible after the Fed stops buying 70% of the new issues of government bonds at the end of June, would probably also produce a similar nasty recession, as new financing became effectively unavailable and government stopped paying its bills.
It is however more likely at this stage that commodity and energy prices will feed through into inflation with only a modest lag (or rather, the increases in the last year have already set up the potential for a major increase in inflation). In that case, with consumer prices rising rapidly, wages will also be forced upwards.
The Keynesian theory that wage inflation is impossible while there is slack in the economy is in this respect simplistic. Over 40% of the current unemployed in the United States have been unemployed for more than six months, an unprecedentedly high proportion (we do not have figures for the Great Depression). There is in addition an immense army of "discouraged” workers who have given up actively seeking employment and have dropped out of the "labor force” as defined by the Bureau of Labor Statistics.
Some of these people have been trained in skills for which there is no longer much demand. Others have skills for which there is theoretically demand, but those skills have atrophied through non-presence in the labor force; for example computer software specialists whose techniques are those of 2005 are now pretty unattractive to an employer seeking to expand in the areas that are growing today.
Finally, others may be trapped by the housing market and unable to move without declaring bankruptcy, existing instead on the earnings of their working spouses. Thus, even without counting those who have descended into the depths of alcoholism or despair, there is a substantial segment of the unemployed who are no longer ready to take the jobs that are on offer.
Anecdotal evidence exists that in many locations and business specializations, the jobs market is already tight. With inflation, employees' wages in those areas will be bid up. Overall, the "effective" pool of employees is far below the nominal pool of potential employees and wage inflation will thus track price inflation. Even in China, a country with an estimated 200 million indigent inhabitants without full-time employment, wages in the coastal cities are rising at more than 20% per annum.
With wage inflation generally tracking price inflation, or even a little above it, purchasing power will expand to meet moderately rising commodity prices and there will be no depression and collapse of commodity and energy prices. Instead, cheap money will drive a vicious spiral of accelerating wage, commodity/energy price and consumer price inflation.
As discussed above, there is no reason why inflation should pause significantly at around 10%. Instead, while Bernanke maintains interest rates close to zero, the monetary force pushing up prices will become stronger and stronger, causing a rapid acceleration of the spiral. This is precisely the force, along with the central bank financing of the government deficit, which produced the Weimar Republic price explosion.
The 1970s scenario, of moderate recession combined with chronic inflation that nevertheless peaked at or around 10%, is thus extremely unlikely. More likely is a recession deeper than the one we are just exiting, combined with a collapse in commodity and energy prices. More likely still is a spiral in inflation, probably to 20% or so by the 2012 election, which would by that stage be accompanied by a return into declining output, as market price signals failed to operate properly.
Bernanke may be right; the commodity and energy price increases may be temporary. But whether or not he is, the quicker we replace his policies with grown-up control of the money supply and interest rates, the better.
Martin Hutchinson is the author of Great Conservatives(Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition,Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com. Copyright 2005-11 David W Tice & Associates.) |
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