By Andy Xie 04.22.2011 18:42
As Inflation Surges, Central Banks Run Amok
Super heroes for the world economy they're not, as the Federal Reserve's inflation-stoking policies prove
Inflation is rising around the world, and none of the major central banks have shown serious interest in containing it. To prosper now, under these inflationary conditions, one needs thick skin.
The Bank of England has the thickest skin of all: It no longer gives excuses for ignoring inflation. The U.S. Federal Reserve is constantly inventing new theories while trying to explain away inflation, and while trying to justify its QE2 quantitative easing project despite inflationary signs aplenty.
The European Central Bank has the thinnest skin of all, and recently raised interest rates to defend its credibility in targeting price stability even though, unfortunately, the ECB won't be able to maintain this stance. The Bank of Japan is still shy, but it will have to out-QE the Fed to help its government pay for post-earthquake reconstruction.
Price stability is supposed to be central banking's main goal. But these days, central bankers think they're super heroes who should rescue the world and make everyone happy.
Inflation, since its negative effects are spread thin and take time to materialize, is ignored. Today's central banking is about so many things except inflation. This is why inflation will worsen for a long time to come. Indeed, inflation is the main theme for the current decade. A change will occur only when the current generation of central bankers is replaced.
Inflation's Hold
When western governments decided to bail out their bankrupt financial institutions in 2008, I foresaw inflation ahead. I argued it would start with commodities and in emerging economies, and then spread to developed economies. But now it seems inflation has already taken hold in developed economies.
The euro zone inflation rate reached 2.4 percent in February and 2.7 percent in March year-on-year, marking the third and fourth months that the rate topped the ECB's 2 percent target. More importantly, it's been on a solid upward trend for the past two years. Inflation's dip in 2008 seemed a temporary phenomenon due to negative demand shock. Actually, structural forces have been inflationary for a long time.
The U.S. Consumer Price Index increased 0.5 percent in March from the month before and 2.7 percent from the same month 2010. The index has risen an average 2.7 percent over the past 12 months, much higher than the Fed's assumed target of 2 percent. However, the Fed insists on focusing on core CPI, which excludes food and energy. That indicator averaged a 1.2 percent increase over the previous 12 months.
The problem with the Fed's view is that its policy is partly, if not mostly, the reason for a rapid increase in food and energy prices. If it continues on this policy track, this price trend will continue. And core CPI will eventually catch up with general CPI.
Britain's inflation rate conveniently fell 0.4 percent from the previous month to 4 percent in March. The decline was cited as the reason why the Bank of England has not raised interest rates. Britain has had an inflation rate above its policy target for nearly two years, but it hasn't raised rates. This seems to be a pattern. Data from a single month hardly matters.
The latest batch of data suggests inflation in major emerging economies seems to be at or close to double-digit rates. As the real interest rate in each of these countries is negative, it's hard to see the trend reversing anytime soon.
This is probably the first time in history that real interest rates are negative worldwide. The fear factor is driving liquidity into inflation-hedging commodities and precious metals. The former accelerates the process of turning loose monetary policy into inflation. Brent crude prices have risen above US$ 120 a barrel, up 50 percent in six months. The FAO food price index declined 2.9 percent in March from February but rose 37 percent from the same month one year ago. Odds are that energy and food prices are still tending upward.
Meanwhile, labor costs are skyrocketing in emerging economies. Inflation is a push factor, since wages must reflect living costs. Hence, a wage-price spiral has begun in emerging economies. This dynamic is strengthened by labor shortages in major economies such as China's. This is why global trade prices are rising for the first time in decades, and the trend will only worsen.
Who Cares?
As inflation strengthens, every government and central bank says it cares. But their actions so far raise serious questions about their sincerity.
Give credit to the ECB. It just raised the interest rate despite raging debt crises in Greece, Iceland and Portugal. Many market observers think the rate move was suicidal, but I think it was smart because it gave the bank room to not raise interest rates later. The euro strengthened significantly recently, cooling inflationary pressure in the euro zone, and giving the ECB another excuse for not raising the interest rate later. I suspect it won't raise rates again this year.
Fed officials are talking about an obscure paper written by of Chairman Ben Bernanke 10 years ago. It argues that a central bank shouldn't raise interest rates to cool inflation during an oil price shock. His idea was that a rate hike leads to a recession and reduces wages. Although people may gain when prices fall, they suffer when wages fall.
The theory sounds reasonable but has many problems. First, it wants to describe high oil prices as oil shock, which suggests a temporary phenomenon. The idea is that demand from countries such as China and India is re-pricing oil, and that prices would soon stop climbing. In reality, skyrocketing oil prices are much more the result of Fed policy than emerging market demand.
Oil prices skyrocketed immediately after the Fed started talking about QE2. And the magnitude of the increase can hardly be ascribed to changing demand. Inflation expectations due to QE2 must be the main driver. If so, the Bernanke paper shouldn't apply here at all. People are talking about it to divert attention and justify the decision not to raise interest rates despite rising inflation.
It's true that emerging market demand is stronger than in the past. This factor works into prices gradually and its impact should not raise per-barrel prices so quickly. Whenever an asset price moves rapidly, regardless of the good stories designed to justify the changes, liquidity is usually the real driver; speculation is not entirely the reason for what we've seen recently in the oil market.
If the Fed continues its current policy, inflation would lift general price levels to support higher oil prices. Hence, people who bought oil a few months ago have succeeding in hedging against inflation from QE2 by profiting today.
Second, the Bernanke paper is wrong because it fails to address expectations. In the 1970s, the OPEC oil embargo triggered a surge in oil prices. That could fit the oil shock description. But now, as central banks try to accommodate, inflation expectations have taken hold, and the price-wage spiral followed. It took a big recession to reverse expectations.
It's sad to see Fed officials and its market cheerleaders pushing lame arguments to justify policies. It shows how intellectually bankrupt the Fed has become.
A big wild card for global inflation is how the Bank of Japan handles Japan's reconstruction costs. The Japanese government's debt is 225 percent of its GDP and a rolling fiscal deficit of 9 percent GDP per annum. Reconstruction costs could top 10 percent of GDP.
It's hard to imagine how the Japanese government can borrow as it has in the past to pay the bills. The BOJ will probably have to purchase a quantity of government bonds to support the Japan Government Bond market, which translates into a QE program that's 10 percent of GDP. That would be about the size of the Fed's QE2 in absolute terms. When global financial market realize what's happening, commodity prices may move much higher again.
Emerging economies such as China and India have been raising interest rates. But after a year of tightening, they haven't narrowed the gap that creates negative real interest rates. Unless they increase the tightening pace dramatically, which is unlikely, the situation is unlikely to change.
The global economy is saddled by a legacy of high debt from the financial crisis, ongoing problems tied to high fiscal deficits, and future costs associated with aging populations. There isn't a solution that does not involve a lot of pain. Starting with Greenspan, central bankers are used to making everyone happy. But that's not possible anymore, which is why central bankers behave like a deer frozen by the headlights of a truck.
The last financial crisis was a crisis stemming from too much debt. Governments bailed out financial institutions, but debt levels did not fall. As a result, economies may suffer for years as debt levels normalize.
Post-Peak Rumblings
Central banks usually wait for a strong economic recovery before dealing with inflation. This time, they don't have that kind of an opportunity. Indeed, the global economy has peaked, even though no one has raised interest rates significantly.
Large fiscal deficits and high debt levels are beginning to erode public confidence. A crisis is brewing. The market and politicians are reacting.
The big fight over U.S. government fiscal policy is the most important example; Standard & Poor's recently downgraded the outlook on U.S. government debt. The market has pretty much assumed that Greece is going to go bankrupt soon. Debt concerns are contractionary for demand. It's extremely difficult for a central bank to tighten when the fiscal side is tightening.
Economists tend to ignore balance sheets and want to focus on maximizing current production, because they think in terms of growing out of balance sheet problems. This sort of thinking is unlikely to work now. Post-World War II baby boomers are retiring, raising pension costs and decreasing growth potential, which adds more fiscal burden.
Without dramatic action soon, most developed countries could go bankrupt. An alternative to technical bankruptcy is inflation. Inflation is similar to bankruptcy because it means paying creditors in devalued currencies. I'm afraid this is the most likely scenario for the future.
Much of the world's trouble today can be traced to the Alan Greenspan era. He managed the U.S. economy and, by extension, the world economy by manipulating asset markets through easing expectations and plenty of liquidity.
During his 18-year reign at the Fed, the world experienced a globalization boom aided by IT improvements. This kept inflation low despite rapid monetary growth, so he didn't have to worry about the consequences of his folly.
Whenever a crisis hit, Greenspan could revive the economy by inflating asset markets. Asset players believed in his Midas touch. The resulting wealth effect inflated demand. He made it look so easy that every other central banker wanted to be like him. But, under the veneer, debt was rising relative to income through each cycle. The Greenspan miracle was just a debt bubble.
I saw what Greenspan was doing a decade ago and wrote frequently about it. I wasn't sure whether he was doing it on purpose, or whether he was just dumb. What he said after retiring, though, suggests ignorance: He said he didn't see any problem with managing an economy through the wealth effect.
The real problem with Greenspan is why the system pushed him to the top. The answer may reveal far more about how the U.S. economy operated during the past two decades. That's because Greenspan didn't write this history. Rather, it was vested interests.
Bernanke is clearly not Greenspan. He is intellectually far superior. I also suspect he's political, as well as intellectually dishonest. Surely he knows that many of the theories he cites to justify his actions are absurd. Some recent revelations about the Fed's lending programs for coping with the financial crisis suggest it's a big machine for U.S. crony capitalism.
When the Asian Financial Crisis hit in 1998, many in the United States screamed crony capitalism. Now, look at what's happening in the United States. When the 2008 crisis hit, the Fed bailed out executives who should have gone to jail, or worse. It's sad to see how low the United States has stooped.
An alternative explanation is that Bernanke is playing a game against China and he intends to win. In other words, he is patriotic. China's monetary policy amplifies the Fed's policy impact on inflation due to its currency linkage to the dollar. In such a dynamic, China has a far more serious inflation problem. Hence, it could see a hard landing before inflation becomes a serious political problem in the United States.
A hard landing in China would bring down commodity prices and reduce inflationary pressure in the United States. Hence, the Fed's policy is sustainable as long as China fails to handle domestic inflation.
Even if China does have a hard landing, though, it would be back on its feet in a couple of years. It's unlikely that the United States will be able to resolve its problems quickly.
So the Fed's policy is, at best, designed to buy time. I'm afraid it's mainly aimed at helping vested interest groups saddled with debt. Negative real interest rates can save them by giving them more time. The sad truth, though, is that many of these people should go to jail. The United States needs a jasmine revolution.
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