THE BEAR'S LAIR The death-knell of Bernankeism
By Martin Hutchinson
The producer and consumer price indexes announced last week were significant in
that they sounded the death-knell of Bernankeism. No longer will it be possible
to inflate the money supply by pretending that inflation in the real economy is
not a problem; other means will have to be found to perpetuate the shell-game.
In previous months, the consumer price index (CPI)in particular had benefited
from some very fishy seasonal adjustments to remain close to the Fed's targets
and only a little above 4% on a year-to-year basis. Even so, the rise of the
producer price index (PPI)at 7.2% in the year to May 2008 should have caused
alarms. This month, all possibility of doubt was lost. The CPI rose 1.1%,
putting it fully 5% above its level in June 2007, while the PPI rose
a staggering 9.2% on a year to year basis.
This puts inflation securely in the 1970s framework. If you look at the annual
figures for 1970s consumer price inflation, you will find only one figure below
4% (and that in 1972, when price controls were in effect) but you will find
several figures, both in the early 1970s and in the 1975-77 period of consumer
price index quiescence, that were in the 4-6% range. Since a major effect of
inflation is psychological, the fact that inflationary pressure has decisively
moved back into the 1970s range is important.
At 5% per annum, inflation cannot be ignored. Investors cannot buy fixed-income
securities without taking account of the fact that the principal of those
securities will have devalued by more than half by the time they are repaid (if
they are of 15 years or longer maturity.) The combination of inflation and
un-indexed income and capital gains taxes rapidly raises the tax rate on
capital returns to an extremely high level, depressing still further the
incentive to save.
In the long run, a society with 5% or higher inflation becomes starved of
domestic capital, and long-term investment falls below its optimal level. More
important perhaps, those such as the pensioners and bondholders who entered
into long-term arrangements believing in the soundness of money have
effectively been swindled by borrowers - particularly, in most cases, by the
government.
My great aunt retired in 1948 with her savings primarily in a three-and-a-half
percent British War Loan; by the time she died in the 1970s she was completely
indigent, since the real value of both her capital and income had declined by
about 85%, as had even the money value of her bonds, which were irredeemable.
She was a lifelong Tory voter and had been a great fan of Stanley Baldwin, so
doubtless the postwar Labour government considered her "lower than vermin"; its
economic policies certainly had the effect of treating her as such. My aunt in
her retirement (she previously had a 40-year small-business career) was a
rentier such as John Maynard Keynes wished to euthanize; gee, thanks Maynard!
Since the inflation statistics have changed their nature, monetary policy will
also have to change. Whatever brave words Federal Reserve chairman Ben Bernanke
puts on it, he will not at this stage be able to switch to "fighting inflation"
wholeheartedly. Genuinely fighting inflation would require real interest rates,
even in the short term of at least 3% to 4% - not maybe as high as the 20%
short-term rate - roughly 9% in real terms - that Bernanke's predecessor Paul
Volcker imposed on the US economy, but nevertheless well above the neutral long
term interest rate, which is well above 2%, probably above 2ฝ%.
That would imply a Federal Funds rate in the 9-10% range, well above the 8%
that would have been sufficient to fight inflation had Bernanke adopted it in
2006-07. Long-term rates would also have to rise to at least the neutral rate,
or around 8% per annum on 10-year Treasury bonds.
As Bernanke would no doubt tell you scornfully, a Federal Funds rate of 9-10%
and a long term bond rate of 8% would devastate the US economy, in particular
causing further carnage in the housing market. Very well, if Bernanke's
monetary policies (and Alan Greenspan's before him) have led the US to a
position in which fighting inflation would devastate the economy, then rates
must be raised in a two-stage process. In the first stage, the gradual raising
of the Federal Funds rate from 2% to maybe 4% over the next year, inflation
will not be fought, and will consequently continue to rise to perhaps the 7-8%
range.
Should he adopt this policy of modest rises in interest rates, Bernanke will no
doubt claim to be fighting inflation, but he will be doing no such thing, since
real interest rates will remain securely negative. However, even though
inflation in general will continue to rise, it will no longer be in an
out-of-control spiral and oil and commodity prices in particular will probably
come off the boil somewhat (though gold, which has not shared in the sharp
commodity price appreciation of the past year, may still soar towards
US$1,500.)
While interest rates remain in the 2-4% range, house prices will continue
declining, but the inflation and the ongoing modest strength (if growth around
zero can be called strength) of the
The US economy will pull wages up towards house prices. The dollar will remain
weak, since US interest rates will remain well below international rates, but
that will have a beneficial effect in rebuilding US export industries and
moving the US current account towards balance. Weakness in housing and in
retail sales will thus be counterbalanced by strength in the export sector.
By late 2009, with house prices down around 30-35% nationwide (and by 55-60% in
overbuilt parts of California, Nevada, Florida and the northeast), the ratio of
house prices to incomes will no longer be unfavorable, and signs will appear of
a recovery in the housing market.
At that point, we will reach another decision node. Should Bernanke be
reappointed for a second four-year term in January 2010, in spite of his
manifest failure to control inflation, he will doubtless keep interest rates at
their low prevailing levels, which will cause inflation to begin trending
upwards more sharply, passing 10% annually in early 2010, at which point real
short-term rates will be minus 6%. The result will be crisis, which it is
unlikely Bernanke will prove capable of solving.
The alternative path will occur if a president John McCain or a president
Barrack Obama does not reappoint Bernanke, preferably asking him to leave
office several months early, and instead appoints a Fed chairman with a proper
commitment to fighting inflation - along the lines of Paul Volcker, although
Volcker himself will be 83 in 2010, presumably too old to want to resume his
old stressful and relatively unlucrative job. In this contest, it is gratifying
that Volcker is already advising Obama, suggesting that his relatively mild
criticisms of current monetary policy will be taken to heart.
With housing stabilized, and the probability of a financial-sector meltdown
reduced, the new Fed chairman - let us call him Volcker II - will be able to
take a strong line against resurgent inflation. The Federal Funds rate will be
increased immediately to at least 12%, which will cause a bond market debacle
as long-term Treasury rates readjust themselves to their new equilibrium level
around 10%.
Housing will go into a renewed funk, but with prices and incomes relatively in
balance it should be a shallow one in terms of house prices, doubtless causing
further bankruptcies among homebuilders but not mass defaults among home
mortgages, the fixed-rate among which will now have interest rates far below
the new market level.
The US economy will enter a sharp recession, somewhat exacerbated by a recovery
of the dollar from the excessively low levels it will have reached during the
easy-money period of 2008-09. However by the end of the slowdown, with the
further decline in retail sales that it will cause, the US savings rate will
have been rebuilt to a modestly positive level and the current account will be
close to balance. As inflation begins to decline and monetary policy to ease,
economic growth will resume, probably in time to help the 2012 re-election
campaign of McCain or Obama.
By 2012, when economic recovery becomes generally apparent and interest rates
begin to ease, the United States will have suffered five years of economic
growth close to zero (and hence negative when adjusted for population growth)
with the construction and financial sectors declining sharply in importance,
and export sectors generally increasing.
Real consumption per capita in 2012 will be well below that in 2007, although
much of that decline will be suffered by the top 1% of income earners who
benefited so fabulously from the cheap-money bubble. Prices will have risen by
about a third over the five years, and there will still be more work to do in
2012-15 before inflationary psychology has been wrung out of the economy - real
interest rates will remain high for some years. However, the recession will
have been nowhere near as deep as the Great Depression, nor will it have been
as prolonged as the Japanese stagnation of 1990-2003.
The real sufferer in the 2008-12 decline will be stock prices. Judged by its
level of 4,000 in February 1995, the Dow Jones Industrial Index should today be
standing at a level of 7,800 (when you increase it in line with nominal gross
domestic product) compared with its actual level of 11,400. That would suggest
a moderate decline of a further 30% from the Dow's current level, a total
decline of about 45% from its 2007 high. However, that fails to take account of
the market’s position in February 1995; at that point it was at an all-time
high, almost 50% above what had seemed the unsustainable peak of 1987.
If we measure the Dow instead by the increase in nominal GDP from its value at
the beginning of the great bull market, of 777 in August 1982, it should bottom
out around 3,400 today or about 4,500 in 2012 allowing for inflation between
now and then. That is probably a more reasonable estimate for the low;
conditions in 2012 will be those of tight money following a lengthy recession,
very similar to those of 1982 but not to those of 1995, which were much
sunnier.
Hence a decline not of 45% but of 70% in the Dow index is on the cards, with
correspondingly severe devastation in baby-boomers' retirement portfolios (only
part of which will be in stocks, but the rest will mostly be in debt, affected
like my great-aunt’s savings by both rising interest rates and inflation.)
If THAT doesn't get people saving like squirrels, nothing will!
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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