A mere six months ago, the Fed was fretting about the danger of slipping into deflation. The deflationary concern from a soft U. S. economy getting softer would mean the demand for U.S. labor would also become softer, implying that U.S. wages and labor income would decline. If, on the other hand, wage escalation was achieved in the standard way of generating demand pressures for U.S.–produced goods, this would lead to greater demand for American labor and solve a lot of our problems.
It would reduce the pool of 7 million U.S. workers who have become unemployed in the Great Recession. It would raise wages that workers could spread among spending, debt reduction, or home mortgage payments — and thus avoid foreclosure and prevent further banking sector erosion. It would also narrow the U.S. fiscal deficit with more taxpayers and fewer recipients of income transfers.
That was the unspoken agenda of ‘Let’s not allow deflation.’ Not since the 1930s depression — and for the same reasons — inflation was seen as preferable to deflation, as it was presumed it would lead to inflation of workers’ income.
Hence QE2 was launched last November. It was based on Keynesian demand-side logic but a funny thing happened on the conventional path to generating U.S. spending. The weight of the U.S. monetary stimulus escaped to the emerging nations where those economies were already revved up from their own stimulus to combat the Great Recession.
How this occurred would require some rehashing of my previous post, “Only the Shadow Banking System Knows”, so allow me to cut some corners. The Fed’s QE2 asset buying program had the effect of putting purchasing power into the asset markets, which are not restricted to only U.S. assets. QE2 became a large funding program for hedge fund expansion of assets that are global in scope, and because the emerging nation’s economies were in better growth mode and had higher returns in capital markets than U.S. assets, much financial purchasing power ended up there.
On top of that, others with wealth who perceived the Fed intervention as being inflationary (indeed the Fed’s stated goal) sought to protect their inflation exposure to fixed income and the U.S. dollar (see Bill Gross’ abandonment of the Treasury market). These investors reallocated to either precious metals as a monetary substitute, hence the gold and silver rally, or to assets in other currencies. Either motivation had the effect of pumping up emerging nations’ capital inflows, currency values and asset prices, which supported additional aggregate demand in those countries.
From there, the link back to the U.S. inflation rate runs through a demand-driven inflation in those parts of the world. For example, Brazil, a major recipient of the financial inflow, is now growing at a 7.5 percent rate with a 6 percent inflation rate. The numbers for China are similar. What this means for the U.S. is that imported products from these lands are now considerably more expensive, both because it requires more dollars to purchase their currencies and more to purchase their goods. The leap so far has primarily shown up in U.S. producer prices that will lead to shrinking profit margins, some cost push-through to higher prices on US produced goods, and lower equity market P/Es.
It’s a general proposition that more demand will run up prices. However, the price response to more demand is not uniform. In particular, products that become disproportionately expensive are those with high income elasticity (food, energy, metals and commodities) on the demand side, and/or products with supply inelasticity. In this case, the cause of explosive price leaps is that both conditions are present for agricultural products, metals, energy and commodities.
The graph below indicates the leap in prices for all four categories (interrupted briefly by the 2008 Great Recession). The price indices are climbing fast and are now more than double the base price index of 2005 and four times their 2001 prices.
Some six years ago the noted investor Jimmy Rogers wrote Hot Commodities and his prediction is prescient. After two decades of under-investment in the new supplies or reserves for the above commodities, these industries will not be able to expand output proportional to greater demand thus generating price pressures for these scarce resources. The other point Rogers makes is that periods of heavy investment in these resources only produce added capacity on a scale in which units of time are measured by decades. Long lead times are required to keep the Inflation Genie in the bottle if the emerging markets are pushing up the rate of global GDP growth.
While these macro responses were coming together we had some piling on of supply shocks, adding yet more to the Genie’s inflationary leap out of the bottle. The epic events in the Middle East transformation, Japan’s multiple shocks, and weather-altering volcanoes in Asia place yet greater strains on the supply capacity in the already scarce agriculture, commodity, and energy space.
So QE2 will go down in history as the Fed’s attempt to generate domestic inflation. It did so, but not in the intended fashion of generating domestic spending and a scarcity of U.S. labor and rising real wages. U.S. labor is the one input price that is stagnant and declining in real terms, as shown in the graph below.
The result will be stagflation, which implies lower real wages with less left over after food and gas to retire debt and spend. The Fed will claim a face-saving victory of generating inflation, but every American will know that we are worse off as they pull up the gas pump on the way to the supermarket.
It’s rare to see polls of confidence in the Fed, and recent polls are not looking good on Main Street, which reports a 30 percent confidence rating. But on Wall Street, the asset bubble keeps the Fed’s confidence rating at 60 percent.
The Fed being pushed off of its QE2 policy is a logical result when it is set to expire soon — though that is not necessarily the case. Stay tuned for the next chapter of the policy saga of how to slip the bonds of the Great Recession without feeling any pain.