THE BEAR'S LAIR Accelerator jammed
By Martin Hutchinson
With the retirement of Federal Reserve vice chairman Donald Kohn, President
Barack Obama now has the right to appoint three Fed governors. Together with
the reappointed chairman Ben Bernanke and Daniel Tarullo, whom he appointed
last year, that will create a Fed Board of Governors on which five of the seven
members are extreme soft-money advocates, and make it almost impossible, even
in a crisis situation, for the 12-member Federal Open Market Committee (FOMC)
to pull together a majority for anything but the most modest increase in
interest rates. Essentially, the throttle will have been jammed open until at
least January 2013. It's worth examining the implications of this for the US
and global economies.
The FOMC consists of seven Fed governors, five of whom after the Obama
appointments will be committed soft moniers. Of the other
two holdovers, Elizabeth Duke (whose term expires in January 2012) is a
community banking specialist without apparent strong views on interest rate
policy, while Kevin Warsh, appointed in 2006, has recently indicated support
for monetary tightening and has said that at some point tightening may be
harsh.
The other five places are reserved for regional Fed presidents, of which
William Dudley, president of the New York Fed and a fairly soft money man, is a
permanent member, the other four places being filled by the other 11 regional
bank presidents in rotation. Of these, Kansas City Fed president Thomas Hoenig,
Philadelphia Fed president Charles Plosser and Richmond Fed president Jeffrey
Lacker have all recently expressed support for near-term monetary tightening.
However, the three presidents will be FOMC members in different years, Hoenig
this year, Plosser in 2011 and Lacker (if reappointed Richmond Fed president
next year) in 2012.
You can do the arithmetic. There will always be a nexus of five members,
including Bernanke and the Obama appointees, supporting soft money, with Dudley
joining them much of the time and San Francisco's Janet Yellen (unless
appointed a governor) reinforcing the soft money forces when on the FOMC in
2012. On the other side, there will never be more than two firm votes for
tightening. Thus until the end of 2012 (assuming Obama appoints a soft money
governor as Elizabeth Duke's successor), there will always be an almost
impregnable majority for monetary ease. Things may change from 2013 - for one
thing, we may have a new president from January 20, 2013 - but until the end of
December 2012, the monetary throttle will almost certainly be wedged at full
open.
In writing about monetary policy over the past year, I have suggested that if
Bernanke himself did not resort to monetary tightening, then either a
resurgence in inflation or a crisis in the government bond market would force
tightening to take place. However, with such an extreme Fed set in place, that
comforting thought may be wrong. With the Bureau of Labor Statistics (BLS)
doing everything it can to suppress reported inflation and the Fed doing
everything it can to put the best possible face on the matter, we may before
late 2012 go through progressive stages of inflation, none of which may produce
monetary tightening.
In the first stage, perhaps for the rest of this year, the rate of inflation
may rise only slowly, in which case its rise will be suppressed altogether by
the BLS though aggressive “hedonic pricing” - seasonal adjustment and
manipulation of the housing component of the index, which represents over a
third of the total and represents no real-world price.
In the second stage, during 2011, moderately accelerating inflation will
finally appear in the statistics, but will be explained away as a temporary
phenomenon, as was the 5% plus inflation of early 2008. Later in the year, as
the "temporary" explanation becomes less credible, the Fed will doubtless
discover a strange interest in the recent paper by International Monetary Fund
(IMF) chief economist Olivier Blanchard, who has announced that monetary
authorities should aim at 4% inflation rather than 2% because it makes
hyper-low real interest rates easier to create. Typical French socialist
rubbish, to be expected from the IMF - 4% inflation over a long period halves
the value of money every 17 years and represents outright robbery of savers.
In the final stage in 2012, when even the BLS's reported inflation nears 10%,
the Fed will resort to three further tactics. It will begin raising interest
rates as it did in 2003-06, by 0.25% at each FOMC meeting, leaving them below
2% even at the end of 2012. It will cite the still-fragile economic recovery
and continuing high unemployment as reasons why it cannot impose the costs of
higher interest rates on the fragile US economy. Finally, it will buy
government bonds in large quantities, following the 1919-23 Weimar Republic's
approach to monetary management, thus (probably with the tacit help of the
People's Bank of China, which will be bought off by concessions in other areas)
preventing the Treasury bond market from staging the collapse which would
otherwise be so richly merited.
By the end of 2012, true US consumer price inflation will be running at 20% or
more, though it is likely that the BLS will still be reporting figures below 1%
per month.
There are a number of corollaries to this. For one thing, if there is to be no
significant monetary tightening before the end of 2012, then the current
commodities bubble will have full rein for another three years. It is certainly
possible that it will burst spontaneously, in which case we will get a
financial crash similar to that of 2008 but with the major hedge funds and
those banks that have foolishly lent to them as the nexus. If no crash occurs,
then by the end of 2012, we will have gold at $5,000, oil at $200 and other
commodities at correspondingly nose-bleed prices.
That's the bad news. The good news is that a period of inflationary finance of
this length would solve the US housing problem, as did the equivalent period of
inflationary finance in Britain in the mid-1970s. In Britain, consumer prices
roughly doubled between 1973 and 1978, so house prices that had been grossly
excessive in 1973 had become once again perfectly reasonable by 1978. There was
thus no great mortgage meltdown in Britain in the middle 1970s. The damage this
caused only became obvious with financial deregulation a decade later; the
inflation of the 1970s had effectively de-capitalized the British financial
system, so that the merchant banks in particular but also the market-making
“jobbers” were woefully unprepared for the piranha pool into which they were
hurled by the Margaret Thatcher government's economically suicidal "leveling
the playing field" in 1986.
This prolonged period of inflation would also be good for the federal budget,
which is why it is unlikely to meet serious opposition in today's Washington.
The deficit itself would be significantly exacerbated, as many spending items
are inflation-linked, as are most income tax brackets. However, the outstanding
debt, including the $5 trillion of Fannie Mae and Freddie Mac obligations that
the government doesn't want its citizens to think about, would be sharply
reduced in terms of either purchasing power or the US gross domestic product.
Thus, even though the path of deficits during the Obama administration would
have been horrendous, the raw increase in the federal debt-to-GDP ratio would
be substantially mitigated by this inflationary phase.
The losers from this avalanche of inflationary finance, apart from any
misguided conservative souls foolish enough to put their money in Treasurys,
would be the People's Bank of China and the other central banks that have
invested their reserves in Treasury bonds and federal agency securities. It's
unclear what China would get in return for continuing to immolate its national
wealth in this obviously misguided manner, but we can be fairly sure that it
would get something. Needless to say, by the fourth year of ultra-loose
monetary policy, in 2012, it's likely that China would be getting antsy about
the losses it was sustaining, and would reduce its support for the Treasury
bond market. This in turn would finally begin the process of pushing up
long-term interest rates to a point at which investors got a positive real
return.
There is no question that by 2012 the wheels would be falling off this
financial contraption, but it's likely that Bernanke, a stubborn man, would
continue in his soft-money convictions for as long as he could, at least
through the 2012 election. To keep the Treasury bond market under control in
that last year, he would resort to yet further swelling of the Fed balance
sheet, buying Treasurys in quantities as large as was necessary to fund the
yawning federal deficit, thereby monetizing it. Until the end of 2012, it's
likely that this policy would not yet have fully exhibited its obvious
downside, so it would be feasible to continue it.
In this scenario, the prospect facing the new president or the re-elected
President Obama in early 2013 would be grim indeed. Inflation would be over 10%
even on official figures, and around 20% in reality. The federal deficit would
still be around 10% of GDP, and the Treasury bond market would only be
sustained at a yield of perhaps 6-7% on the long bond by massive money
printing. Consequently, inflation would be in a mode of rapid acceleration.
At the same time, Bernanke would still have a year to run in his second term,
so there would be little prospect of an immediate clean-out at the Fed,
replacing the errant governors with grownups who could clean up the mess. The
financial system would either have crashed or be imminently about to, while
economically the United States would have been pushed into renewed recession by
the high inflation and massive drain of increased energy and commodity imports.
Globally, only the oil and commodity exporters would be riding high, while
protectionism would be rampant as China, the European Union and other countries
sought to gain assured sources of raw materials in a world where prices were
exploding. Needless to say, the cleanup would take most of the next decade, and
would leave the United States very much weaker at the end of it.
It is always possible to imagine an even worse monetary policy; even in the
Weimar Republic they were lucky to avoid the fate of 1946 Hungary, where
inflation reached 1 quintillion percent. Ben Bernanke and his new Fed cohorts
are about to give Americans, hitherto spared, a painful new object lesson in
the wilder forms of soft monetary policy. It is to be hoped that they remember
its folly for several generations to come.
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 2005-2010 David W Tice & Associates.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
