Inflation, the Fed & Nouriel Roubini
The battle between global deflation and US inflation of the Dollar...
AND NOW to the big subject of the day – inflation, writes Dan Denning for The Daily Reckoning Australia.
You'd think evidence of even bigger deficits in the United States is clearly inflationary. But not everyone agrees. The new prophet of doom, Professor Nouriel Roubini – a tutor in economics & international business at NYU's Stern School of Business – says at least four factors are setting up what he calls "Stag Deflation".
As opposed to the stagflation of the 1970s, where you had no growth and rising prices, he foresees no growth and falling prices – a depression by any other name.
Roubini's four forces of Stag Deflation are:
- slack demand in goods markets;
- a "recoupling" of the rest of the world with the US recession;
- slack labor markets globally, and;
- a sharp fall in commodity prices.
We've already seen Nos.1 and 4, most spectacularly sparking a halving of the crude oil price, plus a collapse in base metals, sharp falls in food-stuffs, and even a 25% retracement in Gold Bullion prices.
But altogether, Roubini says in an article for Forbes magazine, these four factors would "reduce inflationary forces and lead to deflationary forces in the global economy." Since the battle between deflation and inflation matters so clearly to anyone buying equities, bonds or Gold Investment, let's recap and review the situation so far.
"Aggregate demand is now collapsing in the United States and advanced economies, and sharply decelerating in emerging markets," the professor writes. "There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls."
You'll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he's certainly right that there's a big fall in aggregate demand in the US. It's obviously passing through to manufacturers and commodity producers (such as China and Australia respectively).
But won't monetary and fiscal policy designed to combat deflation...you know...cause inflation instead?
Well, Roubini takes that point head on. He says the liquidity measures adopted by the Fed to get credit flowing and recapitalize US banks are not all inflationary. He says once liquidity is restored to the credit markets (and banks begin lending, while money market funds starts buying commercial paper to fund new trade and transactoins again) the central bank can simply "mop up" excess liquidity before it seeps into the real economy to cause inflationary damage.
And what about the tendency of governments to fight debt deflation by inflating the supply of new credit? Not a worry either, says Roubini. He says that most of the household debt in the US is short-term variable rate debt that's resistant to being "inflated away" by cranking up the printing presses.
But is he right? It all comes down to how much money the Fed and the Treasury are going to need before the recapitalization of the American financial sector is complete, and how they plan to raise that money.
The banks will probably need more capital than anyone's expecting. And we should expect plenty more landmines down the road as well. In short, the Treasury and Fed will need more money. Much more. Yet Roubini assumes the Fed can simply remove the lending backstops it's providing once the market returns to normal.
What if it doesn't and the Fed can't? What happens next?
Governments get money three ways – taxing, borrowing, or printing. You can rule out an increase in taxes large enough to fund the Fed's needs. It won't happen with an economy already contracting. Even if Obama raises taxes, it won't be enough to meet the Fed's immediate needs.
That leaves borrowing and printing. On Sept. 17th, the US Treasury announced a Supplementary Financing Program, initiated at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending backstops. Why? Because the Fed was nearly broke, having lent out pretty much all its reserves of Treasury bonds already.
Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the Dollar-Yen Carry Trades, the Supplementary Financing Account set up by the Treasury has given the Fed nearly $560 billion. Some of that may have gone to AIG, some of it to Fannie and Freddie. Some may go to Chrysler, Ford, and GM...who knows?
But the main point, from Roubini's perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it's not inflationary. The bail-out money is simply borrowed – not created from thin air. So the only thing that would make this armada of liquidity measures and loan guarantees truly inflationary is if the Treasury couldn't go out and sell new bonds to gullible foreign investors. That would force it to use cash-raising strategy No.3 – use the printing press. But as long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.
If we're right here at The Daily Reckoning in Melbourne, Australia, however, and the bond bubble began bursting in late October, then the Treasury's line of credit with global savers is nearing its end. Global creditors will be reluctant to finance American deficits any further. Because isn't that how the world got into this mess in the first place? So in order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the US government has become.
Trouble is, the US can't afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely – printing money. The fancy term for it would be "monetizing the debt". In practical terms, it would mean the Fed buying public debt issued by the US Treasury with freshly printed money. And THAT, we reckon, is super inflationary.
Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you're going to damage the confidence people have in the currency – in this case, the all-important US Dollar. And what's bad for the Dollar would start a fresh surge in commodity, foreign currency and Gold Prices all over again.
Roubini, on the other hand, has been right about an awful lot lately. It's possible the Fed will not be forced to monetize the debt. It's possible that a global contraction is truly deflationary. We don't really know. But we're not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and still be confident it can be mopped up later without causing inflation.
Try getting motor oil out of an engine and back into the bottle.