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Inflation is dead! Long live inflation!

"THE WAY in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical.


   
"'We lent it,' said Mr. Harman on behalf of the Bank of England, 'by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.'



"After a day or two of this treatment, the entire panic subsided, and the 'City' was quite calm..."
                                          
- Walter Bagehot, Lombard Street

LEST ANYONE think that today's central bankers' famously hard hearts instantly melt when their closest constituents start to shed tears, we should emphasise that the following events were merely coincidental.

   
It was only a coincidence that as soon as the National Australia Bank announced it was having to take A$6 billion in assets (with another $5 billion possibly to follow) back onto its balance sheet from its place in the shadowy world of the special-investment-vehicle-conduit, the Reserve Bank of Australia – which had already more than quadrupled the amount of excess reserves it provides to the system – stepped up and announced it would, in future, discount member bank paper, as well as mortgage-backed securities.

   
Nor was the US Fed doing anything out of the ordinary when it reduced the new Lombard-style "discount" rate by 50 basis points...lent the odd billion at the window for a 30-day period...and quietly relaxed regulations relating to the amount of support Citi and Bank of America are allowed to extend to their brokerage arms – meaning that up to 30% (from the previous 10%) of regulatory capital could now be devoted to this noble aim, even if it would provoke a minor seismic disturbance at the graves of Senator Glass and Rep. Steagall, sponsors of the 1933 Banking Act.

   
Previously, the inability of Canadian banks to fund their "off-balance sheet" vehicles had caused a spate of involuntary refinancings, whereby the now-unrollable commercial paper was converted into long-maturity Federal Reserve Notes and the like. Hey presto! The Bank of Canada widened the list of collateral acceptable for its overnight cash injections to include bank paper, commercial, and even single-A rated bonds.

   
Well, they were probably planning to do that all along, eh?

   
It had nothing to do with the sharp rise in credit-default swap (CDS) spreads being suffered by the likes of the clearing banks in London, or with the threat posed to the UK's very own sub-prime, buy-to-let punters by struggling mortgage lenders that the "Victorian" Bank of England finally succumbed to its critics and offered both to allow banks to increase the reserves they hold with it by 6% and to lend up to a quarter of the total at its base rate, rather than at its penalty rate a full percent higher.

   
Then again, British venture capital heavyweight John Moulton did tell a reporter that at a recent breakfast meeting with Bank of England officials, none of them knew what a "CLO" actually was. So perhaps it all was just a quirk of fate.

   
Despite all this demonstrable innocence, the cynic's prime entertainment these past few weeks has been the spectacle of individual bankers seeking to assure an anxious depositor-creditor base that their particular institution was sound – and would soon be back to merrily churning out further multi-million bonuses for its movers and shakers, if only everyone else would be as rational and 'transparent' as they – at the same time that these same worthies were publicly bombarding their lenders of last resort with strident demands to stave off the coming Apocalypse.

   
So, for example, Barclays CEO Bob Diamond spent the weekend reassuring the press that his bank was not hiding a "black hole" before turning round and issuing a forthright call for the Old Lady to pump more liquidity into the system.

   
Meanwhile, Barclays' chairman, Hans Jörg Rudloff – admittedly while wearing his hat as chief of the International Capital Markets Association – said that credit had suffered a "heart attack" and that "if we stay stuck, the patient is going to die."

Vigilant, or Asleep at the Wheel?

   
Isn't life grand when those who have earned riches beyond the dreams of avarice in protesting all regulation, and making an insincere obeisance at the altar of the free market, are so swift to call for an inflationary, state-sanctioned bail-out at the first sign of trouble, so passing all the downside for their misfeasance surreptitiously onto society at large.

   
Even more breathtaking, perhaps was the sheer unblinking arrogance on display at the latest press conference of the European Central Bank (ECB), where the impression given was that Caesar's wife was nothing more than a cheap floozy in comparison to the combination of the all-seeing Norns, rulers of fate in Norse mythology, and those paragons of chastity, the Vestal Virgins, who make up the governing council.

   
The first strangled casuistry advanced was that of trying to deny there was any link between the money market and the wider economy. If so, one would have loved to have heard a journalist ask the imperious M.Trichet why we pay the bureaucrats who gather in Frankfurt their handsome salaries to deliberate so intently about where to set interest rates if they are all so utterly irrelevant.

   
In fact, ironies abound when we consider the ECB, for this is an institution which insists on the stern sounding use of the phrase "strong vigilance" and which makes a great fuss about the monetary "twin pillar" in its analysis. Yet this is also a bank which has simultaneously allowed its balance sheet to balloon alarmingly, growing it 70% in just five years and thus endorsing such an horrendous acceleration in M3 since 2004 that it has taken the aggregate to a 28-year high rate of increase, whether measured in real or nominal terms.

A Stark Warning!

   
Quite what Jürgen Stark's innermost thoughts on this phenomenon are, we can only guess, but it was he who delivered a speech the very next day underlining the fact that while Keynesians may not ascribe any importance to monetary trends as a forecasting tool (we should probably include Dr.Bernanke and friends here), the empirical evidence to the contrary was incontrovertible, as a reproduction of his graphs here helps make clear.

And yet, despite all this, the ECB was not only ready to postpone what had been a widely expected rate hike before the crisis hit, but to announce proudly that an extra long-term refinancing operation would be conducted – one, moreover, to be "of no preset size"!

   
Given that this news was rapidly followed rapidly by a sizeable $31.3 billion reserve add from the Fed (three-quarters of that via term repos), it was perhaps no surprise that the Gold Price jumped by almost $16 to its intraday peak a whisker under $700 per ounce. [Ed. note: The Gold Market has since broken $700 per ounce as the injections of cash have continued.]

   
Indeed, while gold had fallen heavily in the initial dash for cash as the crisis broke (another clear proof that, much as we wish it were, gold is NOT money), this exceptionally liquid, easily storable, totally fungible, scarce, real asset has risen over $50 since the Fed fired up the rotors on its Huey helicopter by cutting the discount rate.

   
In short, it seems the realisation has begun to dawn that all inflationary means will be employed in order to save large parts of the financial system from itself. And so yes, inflation – not deflation – still seems the risk ahead.

   
With more and more assets being forcibly repatriated to bank balance sheets, and with the central banks showing ever more comfort with the business of monetizing said assets (even if this remains mostly indirect, as they repo only the least toxic stuff), the already flighty monetary aggregates are set to take another giant bound skyward.

   
Perhaps the clearest case of this – partly because the data there is the most timely – is that of the United States, where the gain in M2 these past five weeks has been the fastest for a like period recorded in over two decades, barring only the 9/11 episode. Our own proxy for M3 here at Diapason – regressed from bank liabilities and money market mutual fund holdings – has been even more impressive in its acceleration, leaping from below a 10% to nearly 18% annualised growth rate since May.

   
This matters greatly because the implicit assumption of the mass is that rising inflation is not a realistic scenario because of:

1. a confusion about the implications of the localised deleveraging raging through the non-bank sector; and
2. a macro-economic refusal to admit that if enough money is pumped into a faltering economy in the wrong places, prices can rise even as jobs are lost and businesses shuttered.

   
So today, the key thing on which to focus is that the central banks have vowed they will keep the money markets open. Against a backdrop of expanding bank balance sheets and a decline in asset quality, that means they will, perforce, relegate the much-vaunted "price stability" part of their mandate to the background, sacrificing it to what they perceive to be the more pressing need to prioritise the restoration of that same mandate's (frequently incompatible) "financial stability" component.

   
As we reallocate people and capital away from the housing industry; as many of the undifferentiated chancers associated with the leveraged beta crowd and the cut'n'shut credit merchants succumb to a gale of creative destruction; as one batch of credit-led malinvestments is painfully liquidated now its constituents are being starved of oxygen, we can expect unemployment to rise and real output to struggle.

   
However, if the surviving credit institutions remain able to mainline sufficient central bank crack...if the Leviathan of government itself starts trying to spend its way out of trouble as only it can...and if money and credit can be found sufficient outlets (as Leland Yeager once said, you don't need a willing borrower of new money, only a willing recipient), then all this can still take place against a backdrop of generally rising prices.

   
Those prices may not be exactly the same ones rising today, of course, since many of such heretofore favoured goods will inevitably lose their main sponsors in the shake-out. Nonetheless, nominal end demand can still be supported, if by no other means than through an increased dole and a higher headcount in an already swollen public sector; by extra subsidies and protections given to dead-beat industries; by the award of yet more, sprawling cost-plus defence contracts; and through the deficit financing of vast infrastructure programmes.

A Possible Trade for an Inflationary Recession?

   
Autobahnen and Interstate highways may be beyond the pale in an anti-fossil fuel age, but I'm sure we can find some economically-defunct, engineering-impaired, green zeitgeist folly, such as wind parks and tidal booms, at which to throw money, instead.

   
All told, the lesson of the current era should be, as Charles Goodhart so pithily put it, "deflation is a policy choice". Accordingly, each investor should constantly intone the mantra:

"Inflation is dead. Long live inflation!"