Inflation: Real or Imagined?

We appear to have entered a new phase of debate about the direction of the economy and the policies we need to use to get ourselves back on our feet. The story so far is that the conservative coalition of right wing politicians, neo-classical economists, and sundry centrist hangers-on have lost every round of discussion as far as dominant philosophy goes, but have managed to water down much of the actions taken – the weak stimulus package is a case in point – so that they may win the longer term debate about ultimate efficacy.

For the sake of discussion I am going to combine the right wingers into one group and call them Hooverites.

Their philosophy is simple: government is a bad thing and should therefore be minimized at all times. Even when it is obvious that the government affords our only solution to a problem. Under these circumstances the Hooverites retreat to a sort of Puritanical ‘pain is healthy’ mantra and bury their heads in the free market sand.

But every so often they latch onto a new tactic. The most recent example being their ‘fear’ of inflation.

Their argument is that the US risks being punished by the bond markets for undertaking needless and ill-advised monetary and fiscal intervention in the economy. The supposed upshot of this intervention is the prospect of endless, large, and possibly expanding deficits that will inevitably ignite uncontrollable inflation. In other words, and in stark contrast to both the views and actions of a grandee of the right wing – Dick Cheney – deficits do matter to Hooverites.

Many of you may have come across this argument.

This is how you demolish it:

• Economic theory and empirical data do indeed suggest that an excessive accumulation of money in an economy will manifest itself as and increase in prices – inflation – rather than an increase in demand – economic growth.
• The key phrase being ‘excessive accumulation’: this is a relative statement. The excess is relative to the current state of the economy. Basically, the story goes that an influx of money into an economy, where demand is already strong and where the economy is running fairly close to its capacity, that influx will not spur the production of more things – there is no capacity to be brought into use – and so will merely show up as higher prices for things already being produced. This is what we callinflation.
• But what if the economy is nowhere near capacity?
• In this case the money will show up as an increase in demand and the risk of inflation is very low – until capacity is fully employed, in which case see above.
• So where are we now?
• Way, way below full capacity. Indeed that’s our entire problem: we have an economy that has capacity sitting idle everywhere – closed factories and unemployed workers – with demand for goods and services slumping as consumers retrench and save.
• Hence the need for stimulus.
• But doesn’t that build a problem for the future?
• Yes it does. And here we have to be careful, because this is the stage of discussion we our now at.
• The stimulus, bail-outs and the Fed’s extraordinary monetary policies have flooded the economy with money. One result is that the Federal deficit is at record peacetime levels, and another is that the banking system is flush with massive reserves – which is a result of the Fed’s efforts to revive the credit markets. This is the point of contention: Hooverites argue that inflation is inevitable; others, like me, argue not so fast!
• The discussion was ignited by a run-up in US bond rates during late May and early June. The Hooverites took this a signal from the bond markets that inflationary expectations were building. Indeed they were expecting to receive this signal, so any run-up in rates was bound to be interpreted by them this way. Don’t forget that long term interest rates always include a component to cover an investors risk that inflation will erode the value of their asset over time – hence the need for ‘inflationary expectations’.
• But: there are alternative, and very valid, explanations for the same run-up.
• For instance: we have just endured a period of extraordinary risk in the credit markets. this produced an excessive demand for US bonds from investors all over the world because those bonds are seen a ‘safe haven’ – the most reliable place to invest in uncertain times. This extraordinary demand had the effect of reducing bond prices artificially. So it is only natural that as the credit crisis abates the market would adjust back to more normal levels of rates. This happens because some of the investors who ‘parked’ their cash in US bonds during the worst of the storm now take it out and put it back into other, usually higher return, investments.
• So bond rates may move for reasons entirely disconnected from inflation – my simple ‘safe haven’ supply and demand example merely being one.
• Now the Hooverites point to the ‘risks’ of adding more debt from the health care reform plan and argue that the risk of inflation is looming larger.
• So what’s happened?
• Rates have leveled off and actually eased since late June and early July.
• Uhh?
• That’s right: the whole inflation argument has to melt in the face of the very simple fact that the run-up that caused so much brouhaha has faded away.
• But the media still barks on about the Hooverite position as if it is a real threat.
• Why?
• Ideology, not economics. Unfortunately, and I suppose inevitably, the business press is heavily biased towards the Hooverite view. That, however, doesn’t mean they know much. But it does mean that there is a predisposition towards seeing ghosts in data.
• So is the threat of inflation real or imagined?
• Imagined right now.
• But …
• There remains medium term to long term need to pull back all the stimulus – once the economy is back running smoothly again.
• Which is why Ben Bernanke spent his testimony before Congress today describing the plans the Fed has in place to drain away any unneeded reserves from the banking system before it turns up as an unnecessary expansion of the money supply.

Meanwhile we should all expect the Hooverites to hammer away at this argument, even though rates have settled back down.

One last note, think of it this way: back in 2001 investors were happy to be paying 5%+ for US bonds. Now they are paying 3%+. That seems, in very simple way, to illustrate that there has been no ‘explosion of risk’ in the US bond market. Far from it: the market is voting with its feet in favor of the non-Hooverite position.

Not a good time to be a Hooverite.

But they are still very loud.

Addendum Tuesday 11:35 a.m.:

As if right on cue the bond market lowered rates of US bonds after hearing Bernanke’s plans for undoing the monetary infusion. So even the media has to admit that the inflation scare was just that: a scare.