Tuesday, 19 October 2010

Helicopter Ben getting ready for take-off? He ought to

Back in the ‘80s, then-US Fed Governor Paul Volcker used some serious weapons to quell inflationary expectations in the US. Interest rates were hiked to a point where the economy went into recession, excess capacity was established and a veritable press blitz focused on the need to stop inflation. At the same time, like-minded governments in the Western world gave the same message and such a thing as inflation indexing was killed in most countries. And it worked. Over a couple of years, inflation and inflationary expectations were falling rapidly and they have remained on a falling trend ever since.

Now that deflation – or at least disinflation – is a very real possibility, the game is to create some inflationary expectations, hoping it will feed through the economy. The reason is the same as fighting excessive inflation, namely that inflation as well as deflation leads to sub-optimal economic decisions.

The question is how to boost inflationary expectations, and it is not quite as easy as one would expect. Monetarists have told us that inflation is essentially a monetary phenomenon – “too much money chasing too few goods”. But that is clearly not the case now. With excess capacity nearing 10 per cent of GDP in several large countries, including the US, and monetary policy not leading to credit growth, inflationary pressures are totally absent. No matter how much money Federal Reserve and other central banks have pushed into the banking sector, most of it has remained with the banks, deposited at the central bank. It has not led to an increase in credit, and the main effect has been to salvage the banking sector and to recapitalise it by stealth.

Economic textbooks prescribe increased public spending that directly creates demand. With governments across the Western world moving to reduce public sector deficits, this solution is not exactly on the agenda. So rumours abound that now the central banks, led by Fed, are about to introduce another round of asset purchases, also known as “Quantitative Easing”. Which is again supposed to increase the money stock.

It probably won’t work this time either. The rumours have created some minor moves in the financial markets, though. The break-even inflation rate between T-bonds and US Inflation-indexed bonds, known as TIPS, has increased to 2.20 per cent. It means that if US inflation over the coming 10 years is 2.2 per cent, an investor will receive the same real return on a TIPS as on a normal government bond. 2.2 per cent is obviously higher than Fed’s assumed inflation target of 2 percent. Thus the situation receives quite some attention in the financial press.

But bond dealers do not create inflation expectations out there in the real economy. Such technicalities have nothing to do with how the average consumer perceives of the world. He/she begins to expect inflation once everyday goods and services begin to increase. We need the price of homes, groceries, haircuts, child care and so on to increase before inflation becomes tangible. At this moment in time it appears that only food prices are going up.

So I am very sceptical that Fed’s attempts at creating inflationary expectations through intervention in the financial markets will work. Fed Chief Ben Bernanke (unfairly) earned the nickname “Helicopter Ben” when in 2002 he quoted the monetary economist Milton Friedman’s recipe on how to stop deflation: Drop money from a helicopter. In the same speech Bernanke went on to describe the monetary policy as it is being implemented right now.

The problem is only that as long as Fed buys T-bonds off the private sector, including the banks, essentially it turns some private sector savings into cash. If the cash is not spent, it will not increase demand. Friedman saw clearly that the cash money had to be aimed at people who would spend it.

Maybe Ben should begin to look for his pilot helmet and get himself ready for that helicopter drop.

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