Thursday, November 27, 2014

Is Inflation Returning?

CAMBRIDGE – Inflation is now low in every industrial country, and the combination of high unemployment and slow GDP growth removes the usual sources of upward pressure on prices. Nevertheless, financial investors are increasingly worried that inflation will eventually begin to rise, owing to the large expansion of commercial bank reserves engineered by the United States Federal Reserve and the European Central Bank (ECB). Some investors, at least, remember that rising inflation typically follows monetary expansion, and they fear that this time will be no different.

Investors have responded to these fears by buying gold, agricultural land, and other traditional inflation hedges. The price of gold recently reached a four-month high and is approaching $1,700 an ounce. Prices per acre of farmland in Iowa and Illinois rose more than 10% over the past year. And the recent release of the US Federal Reserve Board’s minutes, which indicate support for another round of quantitative easing, caused sharp jumps in the prices of gold, silver, platinum, and other metals.

But, unlike private investors, Fed officials insist that this time really will be different. They note that the enormous expansion of commercial banks’ reserves has not led to a comparable increase in the supply of money and credit. While reserves increased at an annual rate of 22% over the past three years, the broad monetary aggregate (M2) that most closely tracks nominal GDP and inflation over long periods of time increased at less than 6% over the same three years.

In past decades, large expansions of bank reserves caused lending surges that increased the money supply and fueled inflationary spending growth. But now commercial banks are willing to hold their excess reserves at the Fed, because the Fed now pays interest on those deposits. The ECB also pays interest on deposits, so it, too, can in principle prevent higher reserves from leading to an unwanted lending explosion.

The Fed’s ability to pay interest is the key to what it calls its “exit strategy” from previous quantitative easing. When the economic recovery begins to accelerate, commercial banks will want to use the large volume of reserves that the Fed has created to make loans to businesses and consumers. If credit expands too rapidly, the Fed can raise the interest rate that it pays on deposits. Sufficiently high rates will induce commercial banks to prefer the Fed’s combination of liquidity, safety, and yield to expanding the quantity of private lending.

That, at any rate, is the theory; no one knows how it would work in practice. How high would the Fed – or the ECB, for that matter – have to raise the interest rate on deposits to prevent excessive growth in bank lending? What if that interest rate had to be 4% or 6% or even 8%? Would the Fed or the ECB push its deposit rate that high, or would it allow a rapid, potentially inflationary lending growth?

The unusual nature of current unemployment increases the risk of future inflation still further. Nearly half of the unemployed in the US, for example, have now been out of work for six months or longer, up from the traditional median unemployment duration of just 10 weeks. The long-term unemployed will be much slower to be hired as the economy recovers than those who have been out of work for a much shorter period of time.

The risk, therefore, is that product markets will tighten while there is still high measured unemployment. Inflation will begin in product markets, rather than in the labor market. Businesses will want to borrow, and banks will want to expand their lending. Under these conditions, the Fed will want to raise the interest rate to prevent an acceleration of inflation.

But, if the unemployment rate is then still relatively high – say, above 7% – some members of the Fed’s Open Market Committee may argue that the Fed’s dual mandate – low unemployment as well as low inflation – implies that it is too soon to raise interest rates.

There could also be strong pressure from the US Congress not to raise interest rates. Although the Fed’s legal “independence” means that the White House cannot tell the Fed what to do, the Fed is fully accountable to Congress. The recent Dodd-Frank financial-reform legislation took away some of the Fed’s powers, and the legislative debate surrounding the bill indicated that there could be wide support for further restrictions if Congress becomes unhappy with Fed policy.

Politicians’ desire to keep interest rates low in order to reduce unemployment is often in tension with the Fed’s concern to act in a timely manner to maintain price stability. The large number of long-term unemployed may make the problem more difficult this time by causing the unemployment rate to remain high even when product markets are beginning to experience rising inflation.

If that happens, Fed officials will face a difficult choice: tighten monetary policy to stem accelerating price growth, thereby antagonizing Congress and possibly facing restrictions that make it difficult to fight inflation in the future; or do nothing. Either choice could mean a higher future rate of inflation, just as financial markets fear.

Although the ECB does not have to deal with direct legislative oversight, it is now clear that there are members of its governing board who would oppose higher interest rates, and that there is political pressure from government leaders and finance ministers to keep rates low.

Rising inflation is certainly not inevitable, but, in both the US and Europe, it has become a risk to be reckoned with.

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    1. CommentedROBERT BAESEMANN

      In 1967, I heard Robert Solow give a public lecture in which he stated that the optimal inflation rate would be something on the ordedr of 4%. I have not heard a reponsible fully qualified economist say anything different since then. The apparent exceptions have been and now are economists who court the favore of the banking establishment. The bankers never tire of bleating about their fears of the big bad wolf. Their reasons are clear. They fear that they will need to take risks in order to operate profitably. Taking such risks is the reason we have banks and bankers. Apparently, bankers and those who speak for them hope to use government intervention to create a very comfortable welfare state for bankers and their shareholders. I am surprised to find bankers onthe list of people Mr. Romney calls dependant.

    2. Portrait of Gregor Schubert

      CommentedGregor Schubert

      Oh, no! Having to push the federal funds rate up to 6% would bring us up to the same interest rate levels as in 2000...when US Real GDP growth was 5%! How can that be if Martin Feldstein seems to argue that that level of interest rates would mean fast growth and low unemployment are impossible?

      The solution is this textbook economics insight: Levels of interest rates are meaningless without the context of the economic environment. Yes, the FED might have to raise rates once inflation starts expanding rapidly. However, inflation is the result of demand pushing up against the boundaries of supply in the economy and prices rising as a result. So the inflation will be the result of fast growth and consequently, high interest rates will be warranted and appropriate for that fast-growing economy, just like they were in 2000. On shouldn't look at prices (inflation and interest rates) without considering the economic forces causing the price changes (demand and supply) - it confuses the tail with the dog.

    3. Portrait of Gregor Schubert

      CommentedGregor Schubert

      One has to admire the "invisible demon" nature of this argument: "Financial investors are increasingly worried that inflation will eventually begin to rise" - except that by some dark magic none of these expectations have made it into market prices:
      1. European breakeven 5-year inflation incorporated into inflation-protected bonds is at 1.3% - way below the ECB target of 2%:
      2. US 5-year breakeven inflation rates are at 2% - right at the Fed target:

      So investors in bonds currently are willing to bet their money on the fact that for the next five years Eurozone and US inflation will be at or below 2%.

      Invisible demons! Martin Feldstein knows they are there, but then - they are invisible, so you just have to take his words for it...

    4. CommentedAndrey Shvets

      Inflation can be useful:

    5. CommentedAndres Jaime

      I cant see inflation rising, neither investor worried about it. Five years forward breakevens are trading in multiyear lows

    6. CommentedMark Pitts

      The real issue is debasement of the currency and the destruction of savings, not inflation per se.

      Although inflation is now low, short-term interest rates are even lower. Thus anyone holding cash, bank deposits, or short-term Treasuries loses about 2% of their money each year.

      The only possibility of a positive real return is to risk principal, either by extending the duration or by investing in a lower credit quality. And since this entails risk, there is no reason to believe that the final real return will necessarily be positive.

    7. CommentedRalph Musgrave

      Feldstein doesn’t understand the first thing about banking. He thinks banks lend out reserves. Hilarious. I suggest he Googles the phrase “banks do not lend reserves”. He’ll find plenty of articles to put him straight on that one.

      When the private bank system sees a series of profitable lending opportunities, it creates money out of thin air and lends it out. The Fed can pay 8%, 18% or 28% on reserves: it won’t have the slightest effect.

      As to when reserves drop to their minimum relative to deposits at private banks, that’s a difference scenario: that’s essentially a QUANTITATIVE control. Thus even there, the interest paid in reserves is irrelevant.

      Worse still, if Feldstein’s article is correct in suggesting that the Fed thinks it can constrain lending by bumping up interest on reserves, then the Fed is clueless as well. But then we already know that those in charge of the West’s economies are clueless: otherwise we wouldn’t have had a credit crunch. And having had one, we’d have escaped it long ago.

    8. CommentedPeter Palms

      also Matial law and arming of DHS.The US Department of Homeland Security and the Immigrations and Customs Enforcement Office have placed an order for 450 million rounds of .40 caliber bullets. The amount of ammo exceeds the amount of people that live in the US and many wonder the motives behind the vast purchase. The contractor Alliant Techsystems is the company supplying the ammunition to DHS and ICE and although the agencies claim these bullets are to be used for target practice many believe they have something else in mind. Hollow points are not training ammo. All amunition is leathal. Hollow points are not made for penetration, but rather expansion to create a greater shock, and crush wound.You can’t use HP for target practice because it makes a messy hole in the target material (paper/wood) because it expands, also it’s more expensive. Finally DHS has ordered over ONE BILLION rounds. They even ordered ammunition via other Gov. agencies that do not even use firearms like Forestry
      The National Guard is not the constitutional authority for protecting this country, it is the Militia.On average, the US military used about 70 million rounds per YEAR during the war in Iraq. Are they preparing for wide spread civil unrest.
      President Obama has issued an executive order, titled “National Defense Resources Preparedness”, which instructs the heads of various U.S. agencies to be on standby of the authorization of martial law under by the Secretary of the Department of Homeland Security.
      The order in fact gives Executive Branch immediate to power to seize and control of any and all assets declared as critical to maintain its industrial and technological base and to control the general distribution of any material (including applicable services) in the civilian market
      The order further authorizes the immediate issuance of regulations to allocate, ration, or seize and all materials, including every thing from food, live stock and farm equipment to transportation, energy and even water!
      Under this order the heads of these of cabinets of Agriculture, Energy, Health and Human Services, Homeland Security, Transportation, Defense and Commerce can seize or ration any food, livestock, fertilizer, farm equipment, all forms of energy, all forms transportation and all other materials, including construction materials.
      The order has been issued under the premise that the United States must maintain its industrial and technological base to maintain National Security and National Defense, which includes giving assistance to foreign nations, during times of war and times of peace.
      Some of the oddest provisions include the allocation of water authority to use chemical and biological weapons being delegated to the Department of Defense, and the authority to place items owned by the Federal government in private property as well as sell Federal government property to private individuals.

    9. CommentedPeter Palms

      I disagree. hyper inflation is imminent. Last month, the UK journalist Stuart Jeffries writing in the British newspaper The Guardian observed that "capitalism is in crisis across the globe -- but what on earth is the alternative?" In 1840, the US writer Orestes Brownson in his essay The Labouring Classes, asked the same question: "what shall government do? Its first doing must be an undoing. We want first the legislation which shall free the government, whether State or Federal, from the control of the Banks. a banking system like ours, if sustained, necessarily and inevitably becomes the real and efficient government of the country."
      How ironic it is that 172 years ago, only 49 years after the adoption of the US Bill of Rights, Brownson noted that "at the end of ten years of constant hostility, we know all too well the power of the Banks, and their fatal influence on the political action of the community." He declares further that "uncompromising hostility" against the banking system should be the motto of every working man and of "every friend of humanity".
      Brownson's Labouring Classes is a call to action, virtually at the inception of the US, to put the control of the government back in the hands of the people. "The system must be destroyed¦ The system is at war with the rights and interest of labour, and it must go." How ironic is Jeffries' observation of the current state of affairs, when contrasted to that of Brownson.
      "Today, 164 years after Marx and Engels wrote about 'grave-diggers', the truth is almost the exact opposite. The proletariat, far from burying capitalism, are keeping it on life support. Overworked, underpaid workers ostensibly liberated by the largest socialist revolution in history,China's, are driven to the brink of suicide to keep those in the West playing with their iPads. Chinese money bankrolls an otherwise bankrupt America."
      Brownson not only understood where the power existed, he knew all too well the consequences for the people and the country if they were to rise against the forces of privilege. "On this point there must be no misgiving, no subterfuge, and no palliation." To bring down the banks means that "every friend of the system must be marked as an enemy to his race, to his country and especially to the labourer. No matter who he is, in what party he is found, or what name he hears, he is, [in] our judgments, no true democrat, as he can be no true Christian."
      Today, Brownson would no doubt have understood that the class warfare caused by the industrial revolutions in the UK and the US has not disappeared; indeed, it might be said that the past decades of "de-industrialisation" in America and the shipping of America's industries to foreign countries have resulted in the barons of industry outmaneuvering the workers, depleting their numbers, savaging their unions and destroying the middle class.
      Some days ago the US channel Press TV contacted me as a possible participant in a new show that concentrates on finance. "Below is the topic of our talk. I really think it is for you," the channel said. The e-mail noted these points of focus: securitization, the asset-based economy and fractional reserve banking (creating money out of nothing); banks and US politics: how the big banks purchase favourable legislation and influence politics; the Federal Reserve System (what it is and how it operates and shady, behind-the-scene deals and practices); the Jewish domination of the US and European banking systems, from the German Jews and the Rothschild banking family to the current near monopoly of modern Jewish dominance; the sub-prime mortgage crisis, bankruptcy and bailing out of the "too-big-to-fail" banks and the failure/collusion of the rating agencies; the shadow banking system and non-bank banks/institutions and their role in the current great recession; monetary and fiscal policies (quantitative easing/printing money) and related macro/micro-economic effects and side-effects including inflation, accumulation of debt and deficit.
      I declined. While I appreciated the opportunity to talk about Wall Street, my real interest in economics is not what Wall Street is doing and why, but why Wall Street exists at all. My concerns go back to the founding documents of the US and indeed those of any country that claims to be the securer of its citizens' rights. Wall Street is a beast created by bankers, private bankers, using the money that belongs rightfully to the people of the country. The economic system of any truly democratic state should serve the state so it can be responsive to its citizens. This system I have called "nationomics", a non-profit system serving the citizens and not profiteers.
      Only a country can create a currency for its people as stipulated in its constitution unless the people's representatives have given that right to private banks that are based on profit and usury. That was the case in the United States when Congress created the Federal Reserve System in 1913. In effect, Congress gave the American citizens' rights and their tax dollars to those who borrow from the Federal Reserve, while these private bankers made enormous profits through interest and the issuance of money they did not hold, for which they charged interest, all backed by the taxes of the people of America. Thus are the people of the United States and their children held hostage to a corrupt system.
      People have the right to demand that the state protect them, keep the nation secure and provide for their health ("right to life" in the US constitution, which means health) and their common good. Yet, the opposite is true in the West; the Bank of England, like the Federal Reserve Bank in the US, is owned by a private family/corporation like the Rockefellers/Rothschilds. Even the gold reserve in Britain is owned by these banks, and, not to be outdone, the newly minted United States in 1791 chartered the Bank of the United States, almost 100 years after the Crown chartered the Bank of England, as a privately owned corporation with the US government holding only 20 per cent of the shares.
      Consider that these banks borrow money from the Federal government, paying a paltry percentage for that favour, then loan that money out to citizens and entrepreneurs et al at generally exorbitant interest rates ranging from five or six per cent to 30 per cent; indeed, they set the rates and they benefit from inside knowledge to gouge the government of the money it receives, taxpayers' money.
      "The super-rich are currently hiding away wealth estimated between US$21 trillion and US$32 trillion in tax havens such as Switzerland and the Cayman Islands," according to writer Ernst Wolff, who also notes that "in 2005, the estimated offshore assets of the super-rich amounted to US$11.5 trillion. Since then this total has doubled or tripled. Today the top 10 per cent of the world's population control 84 per cent of its assets, while the bottom 50 per cent have access to just one per cent. The top of the pile, 92,000 people who constitute an infinitesimal fraction of the world's population, have hidden financial assets amounting to more than US$9 trillion, an average of nearly US$100 million apiece." These hidden assets would eliminate roughly three-quarters of America's estimated debt.
      Consider as well that the major corporations benefiting from the largesse of the Federal Reserve System also stash away their profits to avoid paying taxes to the very Congress that must raise the debt ceiling every year to keep the budget afloat. "The world's 10 largest private financial institutions, including Deutsche Bank, moved more than US$6.25 trillion offshore in 2010," Wolff writes. Perhaps of even more interest to the beleaguered US taxpayer is the ability of the favoured wealthy, even in underdeveloped countries to which taxpayers' money has gone in the form of loans, to hide their money, thus denying its use for vital services to their fellow citizens.
      "In the past 40 years, the wealthiest citizens from 139 developing countries hid away non-declared assets estimated at US$7.3 trillion to US$9.3 trillion in tax havens. Their offshore assets are often greater than the national debt of their respective countries and play a major role in the lack of money to finance urgently needed public health and education programmes in their home countries," writes Wolff.
      That's usury plain and simple; we are just beginning to understand how criminal and greedy this system is, as the recent debacle over the London Interbank Lending Rate (LIBOR) demonstrates. Note how merciless this system is, simply because it is accountable to no one. When a citizen fails to pay a mortgage because the value of a house collapses to its true market value, the banks don't readjust to the market. They foreclose on a house they mortgaged at high rates and then gamble on the failure of their actions, knowing how risky their ventures were. And since they have access to US politicians through campaign contributions to both parties, in affect buying the people's representatives, they determine how the taxpayers dollars are distributed in a vain attempt to right a Ponzi scheme they themselves designed.
      By contrast, a national bank working with state banks could provide the dollars for the states to function at low rates, knowing that all they needed to cover non-profit costs would be the value of the services being covered. No trading on phony mortgage schemes, no destroying of another nation through exorbitant interest rates that get higher and higher as the country goes into default through "austerity" measures that need not exist, followed by Wall Street vultures seeking ways to capitalise on the economic chaos while people are unemployed and desperate.
      Take the usury out of banking and the profit schemes used to create wealth without creating anything but phony paper, and tax money could be used to put people to work, knowing that whatever they earned would be recycled into the nation's economy, items bought and jobs created. Give it to the bankers and it leaves the US for the Cayman Islands, with nothing offered to replenish the coffers of the taxpayers.
      The solution is to abandon the banks and let them slide into oblivion, into the slime they represent. Since the only money they can demand belongs to the citizens, they have no money to use should their existence be denied. What power they have has been given to them by corrupt politicians; they too should be thrown out. The US government has responsibilities to its citizens first and to the economic system as it serves that goal. The bankers can demand what they want, but without the currency of the state available to them, they must resort to the courts and to the people that pay them, the taxpayers.
      The 19th-century president Abraham Lincoln in a time of crisis financed the US Civil War by issuing United States notes without interest. We in the US are in a time of crisis today, and we too could issue notes and cease functioning within the Federal Reserve System -- indeed, pay it off with such notes -- and return the control of the economic system to the government.
      How ironic that banking built on the premise of the Federal Reserve depends on a guarantee of payment based on taxes, which is a socialist system at its core, true socialism at its finest. No one speaks about this insidious, parasitic system that bleeds the taxpayer to keep its profits flowing. Ironically, as the barons have joyfully moved their industries out of America in order to capitalise on wage-slaves in underdeveloped countries, they have drained America of its middle class, which can no longer continue the flow of taxes since their jobs have been cut, close to 15 million unemployed these past five years, and the Congress must raise the debt ceiling and borrow more billions to pay the bankers who demand their payback even as they concoct schemes like derivatives to milk the failed system they have created.
      This brings us back to Orestes Brownson, as he longed to see the America of 1840 attack the barons and bankers. The rich, he noted, will never voluntarily acquiesce to equality of income or parity of living, since "we know too much of human nature to believe that this will ever be effected peaceably. It will be effected only by the strong arm of physical force. It will come, if it ever comes at all, only at the conclusion of war, the like of which the world as yet has never witnessed, and from which, however inevitable it may seem to the eye of philosophy, the heart of humanity recoils with horror."
      Can anyone doubt that capitalism is a failed economic system? How many times must it fail for people to accept that fact? Yet, the US press and representatives and US schools keep up a thundering drum beat of regurgitation to keep it afloat when its very existence has been made possible by taxpayer buyouts of its failed policies. But, like the US writer Ayn Rand, one needs to keep living and pushing to that objectivistic end, self-gratification at any price, even if it means living off the dole. How ironic.

    10. CommentedStéphane Genilloud

      Apart from the predictions of the new classical model, that have been repeatedly proved wrong for the past five years, what kind of evidence do you have that supports your fear of inflation?
      Certainly not future interest rates (see Krugman:
      So, when you say that "financial investors are increasingly worried that inflation will eventually begin to rise", that's just not true. You may be worried, but the market is not.

        CommentedStéphane Genilloud

        @Mark Pitts: the point is that what Krugman says is that long term rate on inflation-indexed bonds are at record lows. This means that the market does not believe at all in the return of inflation in the mid-term, which contradicts the article of Mr Feldstein.
        This does not mean that inflation will not eventually return, just that the market does not fear it.

        CommentedMark Pitts

        If the economy never picks up, Krugman may be right. If it does pick up, Feldstein will probably be right.

        In other words, the unanticipated slow growth in the worldwide economy for the last 3 years has contained inflation, at least for now. It remains to be seen who is right when (or should I say "if"?) things return to "normal."

    11. CommentedProcyon Mukherjee

      Federal Reserve Bank of New York post of yesterday (29th August 2012) by Kenneth Garbade and Jamie McAndrews goes one step further (in the reverse direction than the article by Feldstein) to suggest negative interest rates, which could spark off new innovation that would bring in new products and services to the market as borrowers will receive interest and creditors will have to pay (as new banks could mushroom to hold the cash that people would be rushing to convert from other forms of money, or people could be willing to take out unproductive money from all over the places and pricing of the contingent risk to the market is yet to be ascertained, etc).

      I was amused by one part of the story in this report of negative interest rates, that people would be willing to pay in advance for any service which people otherwise wanted to enjoy credit for. Does this not sound just as coming from another world, where the word inflation does not exist? How could we have two diametrically opposite views from the same community of people, one prescribing that inflation has already arrived and the other blatantly authorizing another bout of money supply that would take the interest rates to the negative territory and both these prescriptions are being made simultaneously on 29th August?

      Procyon Mukherjee

    12. CommentedRoss Clem

      Is the creation of reserves by the FED replacing private savers as the source of saving and causing people not to save?

    13. CommentedRoss Clem

      Why expand reserves to stimulate the economy while at the same time pay interest upon them to reduce their "inflationary" effect?

    14. CommentedRoss Clem

      They have also been investing dollars overseas thereby transferring the effects of the monetary expansion to foreign countries.

    15. CommentedFrank O'Callaghan

      Of course inflation is returning! First lower interest rates so that more borrowing occurs, 'cheap money' makes it easy for the gullible to 'buy' the loan. Secondly do the same for governments. Thirdly, for the governments who don't want to borrow, cause a crisis that requires some short term borrowing. Fourthly and finally, up the rates. Presto! Instant permanent financial slavery! Higher interest rates can be 'justified' by inflation.

      This is merely the scamming of the retiring post war baby boom coupled with the impoverishment of the millennials and their older siblings. The tragedy is that with a little redistribution in the egalitarian direction of wealth, power and leisure we could have a much better set of outcomes for all but a tiny gang of billionaire plutocrats.

        CommentedMark Pitts

        Actually, it works in just the opposite fashion from what you postulate: inflation generally favors those who borrowed, and penalizes those who saved and lent the money.

        In other words, to the extent that billion plutocrats are lenders (and they are), inflation is a wealth transfer from them to the middle class and to governments.