Inflation, Deflation, And Rising Interest Rates

I receive a number of questions on economic and monetary matters. Lately these three have persisted.

Q. Will the rising oil price lead to higher gas prices and therefore higher inflation rates?

A. No, not in themselves. Inflation expresses itself as an across the board increase in prices. This can only occur through increasing amounts of dollars chasing goods and services. If the money supply remains contained to small increases, so will the rate of inflation. The fact is that it is impossible for higher gas prices to create inflation. All things remaining equal, any increase in gas prices to the consumer must come at the expense of other goods. Higher prices of gas must result in lower prices elsewhere over time. So, it is impossible to have a progressive across the board increase in prices just because some prices spike. The fact is that the last four years have seen gas prices at the pump increase as the inflation rate has fallen.

In the 70's the Fed was confronted with sharply higher gas prices as a result of an OPEC oil embargo. This lead to a generalized recession in the economy as the higher prices served as a tax on consumers. Prices began to fall along with wages. The Fed decided to monetize the higher gas price by artificially increasing the amount of money in consumer’s hands year after year. This was one factor that led to the progressive increase in inflation rates from 2% at the start of monetization to 14% at its peak. Money supply continuously increased and was immediately transformed into higher prices as the new money was spent.

(During the mid-60’s through the 70’s, most economists decided that the money supply had little to do with inflation and decided to monetize government debt to pay for government expenditures including a growing welfare state and the rising cost of the Viet Nam war.)

I've been arguing since QE began, that the Fed has not been monetizing government debt and that inflation would remain low. The Fed has been pursuing an anti-deflationary policy since the financial crisis began. Instead of increasing money in circulation that chases goods, it has increased bank reserves to prevent a contraction in the money supply and a subsequent liquidity crisis and deflation.

The question today is whether the Fed can continue to prevent deflation, or whether QE has become impotent. Each round of QE has been met with smaller increases of inflation. Today, we are at historically low rates of inflation even as we are at historically high levels of money creation. Either the Fed gets money circulating in the economy and the velocity of money picks up or we could see actual deflation.

Q. Why is deflation a bad thing? Why not allow deflation to take hold and enjoy lower prices?

A. Deflation is not a bad thing in normal times. As a matter of fact it is a natural process and existed for centuries under the gold standard. Prices generally rose by about 2% a year then turned around and fell about 2% a year for most of our history. The swings took place over decades. Instead of a Federal Reserve System that controlled the money supply, money levels were controlled by the amount of production of gold mines, and the importing and exporting of gold.

As a country imported more goods, it paid for its imports with gold. Money flowed out of the importing country, and as the money supply decreased in that nation so did domestic prices. As money flowed into the exporting nation, prices rose and became relatively more expensive to other nations. The importing nation would then begin to import less foreign goods and export more of its now relatively cheaper domestic goods abroad.

This was the case under the centuries of the gold standard. As money flows into exporting nations, prices rise and as money flows out of importing nations, prices fall. It is a teeter-totter affect with equilibrium at its center. It was a natural and continuous virtuous cycle made possible by free trade among nations.

For more information see "The New Gold Standard" at Amazon.com

So trade flows plus gold production determined inflation and deflation under the gold standard. The net result over the 18th and 19th centuries for example, was zero inflation on average. A gold dollar represented approximately the same purchasing power at the beginning of the century as it did at its end.

But this is not the system we have today. We are completing a hundred years of monetary policy under the Federal Reserve System. Since its inception and to this day, we have seen the value of the dollar depreciate some 97%. Gold rose from 22 dollars an ounce which it had been pegged at for almost three centuries, to over 1900 dollars an ounce during the time the Fed has taken charge of the money supply. The job of the Fed, if exercised properly is to, as Alan Greenspan put it, "approximate a gold standard" by controlling inflation. It failed miserably in that attempt for most of its existence. But I must say that since Paul Volker, the Fed has done much better than ever before. The rate of inflation has progressively fallen since then to the lowest level recorded since World War II.

So why not allow inflation to continue to fall and permit a natural deflation to occur? The reason is that we and the rest of the world are in the process of de-leveraging the financial system. This is tricky business. We need to slowly back out of our highly leveraged economies the way we came in; and that means slowly reducing the amount of leverage in the system so as not to encourage a financial collapse.

The Basel III agreement just signed has notified all banks around the world that they must increase the amount of capital they hold. This is the second increase in five years. During the gold standard banks held 20 to 25% of their capital in reserves. Today it's more like 6-8%, so we have a long way to go to "approximate a gold standard". But it’s a start.

The transition needs to be slow and steady, like letting air out of a balloon. The financial system is so leveraged and so vulnerable that it is not ready to stand on its own two feet yet, it would collapse of its own weight. Any downward pressure such as a dramatic fall in prices, or major currency or interest rate movements, would only serve to undermine the entire system and invite collapse. This is not a rational alternative. The Fed's goal of trying to keep inflation close to 2% per year is not unreasonable in these times.

We have avoided the mistakes made by the Fed during the 30's that led to a deflationary depression and the country is better off for it. Other central banks have imposed tight money and have fallen into recession and deflation in some cases. It is obvious now that Bernanke was right in the path he took, and the others were wrong, and virtually every nation has changed policies and is now following the Bernanke play book almost verbatim. Even Japan has decided to abandon its 25 year experiment with tight money.

We have learned much in the last thirty years. Foremost was, not to tighten money in the face of financial stress -- and not to allow financial stress in the first place by allowing leverage to go unchecked.

Q. Long Term interest rates have shot up recently. Has the Fed lost control of interest rates?

A. The Fed never did have control over long term interest rates. They can directly control the fed funds rate; and they do have influence over the longer end of the curve, but the bond market is too big to maintain direct control over. There are various ways of measuring the size of the bond market. Most would agree that all bonds including mortgage backed securities plus corporate and miscellaneous government debt instruments amounts to about 37 trillion dollars. The trading volume in the bond market is over 800 billion dollars per day. Obviously 85 billion in purchases by the Fed, spread over a period of a month (2.8 billion a day) is a token amount in this huge market and can hardly move the market as a whole.

It has been claimed that the Fed is purchasing most of the new issuance of new government debt, but this is simply wrong. The Fed is prevented by law from purchasing new debt in the primary market. They can only purchase it in the secondary market.

The primary market is where new debt is issued and bought, and if you look at just that market and calculate it against the 85 billion of Fed purchases per month, then yes you can say that as a percentage of new debt being issued, the Fed is buying an equivalent amount. But in fact they are not buying any of it. It is a mathematical and theoretical number only, and as such, a fiction.

Such small amounts of purchases in the secondary market can scarcely move interest rates. However, the purchase of mortgage backed securities is far more affective in influencing mortgage rates since the MBS market is so much smaller than the treasury market. But even so, mortgage rates have still moved up in the face of the Fed buying some 40 Billion in mortgage backed securities a month.

The Fed only controls the overnight fed funds rate which banks lend to each other. At any time and for any number of reasons long term interest rates can move higher and there is nothing the Fed can do to stop them. They tried very hard in the late seventies and watched them soar to over 20% in a matter of months and there was nothing they could do to stop them then – and there is nothing they can do to prevent them from going higher now if the market wants to take them higher. The market is in control, not the Fed.

We may be at the beginning of a substantial move in interest rates in the future as the 10 year note just moved from 1.6% to 2.7%. This is one of the fastest and largest moves upward we've seen in long rates in decades. The market may be trying to tell us that real concern over the rising national debt and a turn away from disinflation to reflation may be at hand. We will know in the fullness of time.