Pop-Up Inflation

Cartoon by Jim Gibson

In my last post I worried that inflation is coming back and likened Fed policy to – frying pan, fire, frying pan. In writing that I admit that trends showed there was some room for the inflation rate to fall further and I don’t have a good prediction for when inflation will rise again. The importance of this is that important people keep putting pressure on the Fed to keep the pedal to the metal. Any deviation from this monetary flooding is met with fear. Last week Bernanke happened to mention that the Fed was thinking about reversing policy – and the markets immediately went into the tank.

It is interesting that the markets are testing the Fed. The markets seem to love all that money. But that doesn’t mean it is good for Main Street or for employment. A recent article by Andy Kessler (Wall Street Journal, the Fed Squeezes the Shadow Banking System, May 23, 2013, page A17) explains that the Fed has robbed the private sectors of a lot of government bonds and mortgage-backed securities. All this stuff is sitting in the Fed’s vaults and is not being used as collateral for the private sector’s loans. I love Kessler’s line, “In other words the Fed’s policy – to stimulate lending and the economy by buying Treasurys…is creating a shortage of safe collateral, the very thing needed to create credit…”

James Bullard of the St. Louis Fed is worried that inflation is too low and he wants the Fed to keep stimulating the economy. As Kessler says, that is strangling the economy. Worse yet, the risk of a giant pop gets larger and larger the more money is out there. Bernanke is afraid to remove even a dime of it because of the market’s reactions. It is like promising to go on a diet tomorrow. Really, I have a headache today but I will start it tomorrow. Image how the financial markets are going to react when he finally has to remove some money from the system.

Back to this disinflation thing. It is easy to see why the US inflation rate is not going to increase in the next few months. The most obvious factor is slower expected growth in Europe, China, Japan, and most of the world outside of the US. World economic growth spills over into US markets for good reasons. First, when those countries stagnate they buy fewer of our goods. Thus US export sales decrease. Second, as money moves out of those countries and into ours, this has the effect of raising the value of the dollar. The higher value of the dollar dents exports further but it also makes imports cost less. Both factors push US inflation and inflationary expectations downward.  In my last posting I showed a strong medium-term downward trend in inflation. Clearly both medium- and short-term trends are pushing inflation expectations downward. That means less upward pressure on wages and the prices of various other inputs to the production process.

So long as world economic growth is restrained, it is hard to imagine the US inflation rate soaring back this summer. But damaging risk remains. Many people who worry about global warming admit that temperatures have not been rising in the last decade. But they look beyond all that and focus on what happens if you don’t combat warming immediately.  They are alarmed. Well I am alarmed about inflation coming back and putting us back into another deep recession. Europe will not be in a recession forever. China will find a way to grow faster. Japan may figure out its problems. The US is seeing wealth rise as stock and housing prices return to stable values. Many emerging nations are devaluing and restructuring.

No, these problems do not have to be solved soon or at one time. The way our financial markets work is through bits and pieces of information that begin to form a mosaic. When the image of a stronger world economy starts to emerge it won’t take long for inflationary expectations to rise. It is like the jack-in-the-box – you turn and turn and turn the crank but Jack stays in the box – at least until that critical moment. Jack-in-the-box is fun but not when the Fed is at the crank. If the Fed has not done a thing to impede rising inflationary expectations, we can expect a quick return trip from the frying pan to the fire. And it won’t be pleasant. They can take some of the sting out by starting the process now.