Expectations of inflation which affect the pricing of all asset classes is now far ranging, leaving investors in a state of dissonance. There is a core group who expect inflation – possibly very high inflation – in the future, while another group is firmly convinced that deflation will take hold for an extended period of time. To make matters more muddled there are several core beliefs for the anticipation of inflation. This Part I focuses on the monetary influences for inflation and in Part II that will follow, I will discuss the fiscal basis for inflation.
Recently the National Association of Business Economists (NABE) polled its members on their opinion of the one of the most fundamental inputs to the world of fixed income (bonds) pricing and portfolio allocation. The usual question of what will be the (positive) inflation rate has morphed into a survey of will there be deflation or inflation. Now that the vote is in (drum roll please) we find nearly a dead heat. The results were almost equally divided. That is there is a rare bi-modal distribution of expectations by professional economists who usually take comfort in not being out of line with the consensus and only seek to distinguish themselves with subtle deviations from the mean. Obviously they are not speaking to each other. It turns out there is a reason. They are speaking different languages or have different thought processes and neither is convincing the other group because these thought processes go back to core beliefs and not all went to the same school.
Deflation has been an infrequent occurrence in the post WWII period with the US economy approaching it as a brief adjustment period to a consumer economy after a wartime experience. So where do the deflation thoughts come from and for that matter where do the inflation thoughts come from?
What is common among the deflation crowd is their focus on spending in the goods markets, or rather the lack of it, where prices are determined for shirts, shoes, computers etc. relative to the excess supply capacity to produce those products. Too little demand relative to supply for goods is at the heart of their deflationary forecast and on top of that there are many reasons to believe that demand for goods will be soft for some time to come.
The general reasons cited have to do with employment decline, the decline in hours worked to the lowest level since the depression, job insecurity for those still working and the pressure to repay debt loads that were accumulated to finance the boom of 2003-2007 as banks unilaterally raise rates on existing debt where they can. On top of constrained and uncertain income generation there is also the problem of the meltdown of consumer wealth with a significant portion of the population contemplating retirement as the first wave of the boomers is reaching retirement age. For many (30 percent of the population) their retirement preparation can no longer be postponed.
How long might you ask will these spending head winds continue? Well the rate of debt pay down and consumer de-leveraging is proceeding about at half the rate at which the debt was accumulated from 2003 to 2007 when massive borrowing against home equity at the rate of about $600 Billion per year took place. At this rate it will take nearly a decade for the consumer to de-leverage back to previous debt to income ratios which were still elevated as compared to earlier in the post war period.
Now given this weak spending analysis by the NABE economists what is on the minds of the inflation hawks? Ironically it is also spending but with an assumption that it will increase following the explosion of the monetary base that occurred a year ago when the Fed was forced to undertake various lending programs as the private credit markets evaporated. This caused the Fed to lend to banks, non-bank financial institutions and to non-financial firms through their purchase of corporate commercial paper and now effectively to the consumer given their substantial purchases of residential mortgage backed securities. The Fed paid for these assets with printed currency or claims on printed currency (Member Bank Reserve Deposits) which now sit with banks providing them with excess liquidity well over the over minimum liquidity reserves . For veterans of money and banking or a macroeconomic course this should have the meaning that banks now have the ammunition to ramp up lending to some multiple of the Fed Trillion Dollar increase in the monetary base. The usual multiple is ten so the commercial banking system hypothetically has the liquidity ammunition to lend $10 Trillion which is a lot given that the annual GDP flow rate is about $15 Trillion.
The potential fulfillment of the money supply multiplier that would result in a lending and spending spree the inflation hawks remember well. However there is another constraint that will likely prevent that from occurring because bank lending is constrained by both a liquidity constraint for which there is a monumental excess of a Trillion dollars as well as a regulatory capital constraint which means that bank assets can’t exceed a multiple of about 12 times the bank’s capital or net worth. Given the write downs of the past two years and prospects for additional defaults, it is obvious that banks don’t have the capital base to lend and so the excess liquidity remains excess.
None-the-less, the inflation hawks continue to beat the drum of the coming inflation. The relevant question is when will the banks have the capital to meet the capital requirement to expand and will they lend and will the borrowers be incented to borrow and spend further when they seek to de-leverage?
To some extent the inflation expectations in the market must be accountable to a prior learning experience. To account for the l970 US bout of inflation there emerged a theory. Monetarism or the notion encapsulated in their well remembered Milton Friedman one liner, “Inflation is always and everywhere a monetary phenomenon.” This one liner constitutes the monetarist oath linking inflation to money but how about causation? It says, if one reads it carefully, that if inflation there was more money but is the converse necessarily true that more money necessarily results in inflation? So far not, so the monetarists are chastened and have retreated to the question of when and the specter of inflation remains unfilled in their minds.
The potential of the expanded monetary base setting off an inflation environment depends on a lot of things. It could happen but the Fed seemingly has tools to prevent it. One doesn’t know what the Fed “exiting” the market exactly means and when and whether it will occur but even if the bank liquidity remains in the system the Fed has the authority to merely change the cash liquidity requirements relative to deposits (as the Fed did in similar circumstances in l937) and overnight eliminate excess reserves and hence eliminate the monetary lubricant for inflationary levels of lending and spending.
However in this environment expectations based on a retained core understanding of the financial world takes precedent over details such as the above. This is almost a laboratory experiment. “If the money supply doubles will the price level double” and the irresistible answer for the monetarist is “of course.” Inflation expectations for some have departed from actual inflation because of the belief that that the converse holds and rejecting 30 years of monetarism is a hard thing to do and is causing them to load up on inflation hedges in a world of deflationary pressures. We now are in internal dissonance where economists and market participants no longer speak with one voice or with one unified expectation of inflation with only subtle shading to be distinguish from the crowd.