by Martin Hutchinson
March 21, 2011
At the Federal Open Market Committee meeting last week, policy remained unchanged, and the accompanying statement made the extraordinary claim that “measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.” The following day, the March Producer Price Index showed prices rising at 1.6% per month, equivalent to a rate of 21% per annum. Echoes of the German Weimar Republic inflation are getting louder, as do the chances for Ben Bernanke to turn into Reichsbank chairman Rudolf von Havenstein.
Von Havenstein took great pride in his work, bragging repeatedly about the Reichsbank’s success in gearing up physical note production to meet soaring market demand. Rather than practice or urge monetary restraint, he regarded the explosion of physical banknote production as a triumph of German efficiency. Such was the need for speed, in the fall of 1923 when prices were doubling every 3 days that he was forced to resort to airplanes to get the currency to the more distant economic centers. All he lacked was Ben Bernanke’s helicopter!
The conventional wisdom is that the worst the U.S. has to fear from Bernanke’s policies is a repeat of the 1970s. During that period, inflation proved impossible to contain, but it crept up gradually, with year-on-year inflation rising from 3.6% to 12.2% in 1973-74, then dropping back gradually to a low of 5% in December 1976. Even in the peak inflation year of 1980, year-on-year inflation topped out at only 14.6%, little higher than its level six years earlier. In that situation, while Bernanke might let inflation rise fairly rapidly as it had in 1973-74, there would be little chance of it getting out of control and the economic pain of the eventual Volcker-style squeeze would be manageable.
In such a situation, comparisons between Bernanke and von Havenstein would be ludicrous. I’m as fond of Bernanke-bashing as anyone, but if a period of inflation moderately above 10% were the worst we had to look forward to, I would disagree with the Bernankephile argument that his policies had on balance been worthwhile, but I would concede that they had considerable force. Bernanke himself, who grew up in the 1970s, probably restricts his moments of self-doubt to worrying whether the 1970s might return, which would make him look foolish but not catastrophic.
However, that is not the only possibility for the future track of U.S. inflation. It has to be remembered that both monetary and fiscal policies today are far more extreme than they were in the 1970s. Fiscally, the United States has run a deficit of more than 10% of GDP in both the year to September 2009 and the year to September 2011, while the country’s previous largest peacetime deficit was 6.3% of GDP in 1983. This is a bipartisan complaint; an administration that inherited a budget surplus and yet managed to end up running a substantial deficit even at the top of the next boom cannot claim fiscal rectitude.
Nevertheless, whoever is to blame, the result has been a deficit position that looks out of control even on the administration’s optimistic fiscal and economic projections. The actuarial deficit in social security is a genuine problem, made even worse by the dodgy “trust fund” accounting that has allowed the creation of a fictional trust fund whose assets consist of debt not counted in official statistics. The actuarial deficit in Medicare is less serious, because it principally rests on an assumption that medical cost increases will continue to outpace inflation ad infinitum, which won’t happen because it can’t. Nevertheless, the principal fiscal problem of the last few years, as distinct from that projected for the next decade, has been profligate domestic and international discretionary spending, a problem that is being tinkered with at the edges but appears increasingly unlikely to be addressed properly.
Bernanke cannot be blamed for U.S. fiscal follies, any more than von Havenstein could be blamed for the fiscal ineptitude of the Weimar governments of 1919-23. However monetary policy is his clear responsibility. In this context, the most alarming statistic is the monetary base, which has expended from $900 billion to $2.35 trillion in the 30 months since September 2008 and has been expanding at the extraordinary annual rate of 83% since December, as Bernanke’s QEII asset purchases have come into play. In this effort, the Fed’s balance sheet has swollen from $800 billion to $2.6 trillion, with $300 billion of that increase coming in the last four months through QEII purchases of Treasuries.
Bernanke’s problem is that the mix of gigantic deficits, interest rates below the rate of inflation and gigantic central bank purchases of government bonds is precisely that of the Weimar regime. Admittedly the Reichsbank by October 1923 was financing 99.9% of government spending and we haven’t got to that yet. Still the budget deficit represents more than 40% of government spending and during the QEII period the central bank is financing about 70% of the government deficit. That’s pretty close to the early Weimar period of 1919-22, when the Reichsbank was financing about 50% of the government’s expenditure compared to about 25% of expenditure in the United States today.
With both fiscal and monetary policy much more extreme than in the 1970s, there is no reason prices should merely creep up at 1970s rates. While the price indicator figures produced last week appeared fairly benign, with the CPI having risen only 2.1% over the past year, that relatively benign figure includes a significantly more rapid rise, at a 3.8% rate, in the last six months. What’s more, prices at an earlier stage of the production cycle have been rising much more rapidly, with the Producer Price Index rising at 10% in the last six months and import prices rising at 14.5% in the same period.
Keynesians would immediately claim that high unemployment dampens these price rises, and that a sharp rise in inflation is impossible while there is so much labor slack in the economy. However that view is belied by British experience in 1974-75 in which economic activity declined, unemployment rose and inflation rose to 25%. Unemployment is in any case well down on the last two years and the labor market in a state of mild expansion.
If Bernanke persists on his present course, there is thus a significant chance that consumer prices will join producer and import prices on their rapid upward trend, and that by the end of the year we shall be suffering from 10% consumer price inflation. Bernanke and his colleagues will at that stage be in state of deep denial, focusing on “core” consumer price inflation (distorted) or personal consumption expenditure inflation (available only several months after the event.) If by the end of 2011 inflation is running at rate of 10%, even though the year on year figure will not have reached this level, while Bernanke’s current monetary policies and the Obama administration fiscal policies have been little if at all modified, then the outcome is plainly clear: inflation won’t stop at 10%, as it did in the 1970s.
In that case, Bernanke’s chance of joining von Havenstein in the monetary Chamber of Horrors will be pretty high. The gap between interest rates and the inflation rate will be close to 10%; thus a 10% or more increase in interest rates will be needed to start getting inflation under control. Naturally, any such increase will be anathema to Bernanke; it would represent a repudiation of everything he believed in. He will thus remain relatively inactive while inflation accelerates further. Far from corralling the inflationary monster, the Fed will be reduced to running ineffectually behind it as it galumphs off into the distance. You can expect Bernanke at that stage to start issuing press releases about the Fed’s immense technical achievement in printing and distributing enough notes to satisfy the public’s insatiable demand for money. The transformation of Ben Bernanke to Rudolf von Havenstien will be complete, although the trillion percent inflation figures will have to wait until 2014 or so.
Is this fate avoidable, for Bernanke and the rest of us? Certainly. But it will require the Fed at its next meeting April 27 to reverse policy entirely, to admit that inflation, far from being “somewhat low” is an imminent danger to the U.S. economy, to stop buying Treasuries and to put the Federal Funds rate up to at least 2%, with a view to raising it to 6-7% by the end of the summer. It is thus not impossible. But given Bernanke’s outlook and the present composition of the FOMC, it must be regarded as extremely unlikely.
The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.