Thursday, June 27, 2013
Risk of 1937 relapse as Fed gives up fight against deflation
It has set off an emerging market shock and risks "blowback" from a fresh spasm of the eurozone debt crisis, and it is letting all this happen at the same time, before the US economy is safely out of the woods.
It has violated its own counter-deflation strategy, tightening monetary policy even though core PCE inflation has fallen to the lowest levels in living memory and below levels deemed dangerous enough in the past to warrant a blast of emergency stimulus. It is doing so even though the revival of bank lending has faded.
The entire pivot by the Federal Open Market Committee is mystifying, almost amateurish, and risks repeating the errors made by the Bank of Japan a decade ago, and perhaps repeating a mini-1937 when the Fed lost its nerve and tipped the US economy into a second leg of the Great Depression. "It’s all about tighter policy," was the lonely lament by St Louis Fed chief James Bullard.
The Fed seems to be acting in the belief that the US economy will shake off this year's fiscal tightening - 2pc to 3pc of GDP - and that a housing recovery is now entrenched. The sharp fall of Wall Street's homebuilders index would suggest caution. Unlike the surging Case-Shiller index of house prices, it looks forward, not three months backwards.
The Fed could have kept policy steady, welcoming the shake-out in frothy markets over the past month as a useful "fire-drill" for future QE exit, without pushing its point too far. It chose to escalate.
It raised the unemployment target from 6.5pc to 7pc. It concocted feeble excuses to explain why it was ignoring a plunge in 10-year TIPS that serve as a proxy of long-term inflation worries. While still pretending that the pace of QE exit would be dictated by the health of the economy, it in fact set a date that disregards the economy. "Policy actions should be undertaken to meet policy objectives, not calendar objectives," said Mr Bullard acidly in his dissent.
That the Fed should tighten even as it cut its own growth and inflation forecasts for this year is a bizarre state of affairs. "A more prudent approach would be to wait for more tangible signs that the economy was strengthening before making such an announcement. You can communicate it one way or another way, but the markets are saying that they’re pulling up the probability we’re going to withdraw from the QE program sooner than they expected, and that’s having a big influence," said Mr Bullard.
Tim Duy from Fed Watch said the bank seems to be looking for any excuse to extricate itself from QE "as soon as possible". Its reflexes have changed. It aims to press ahead with bond tapering come what may, retreating only if growth really tanks and news is shockingly bad.
This is not just a debate over whether or not to reverse QE, or whether markets have become addicted to Fed amphetamines. It is whether we still knows what on is going in the heads of those who command our destiny, those who have, with other central banks, bought up almost the entire $2 trillion issuance of AAA bonds worldwide over the past year, and therefore have become the market themselves.
The young Fed governor Ben Bernanke warned in his famous 2002 speech - entitled Deflation: Making Sure "It" Doesn't Happen Here - how corrosive it would be if America began to slither down the same slope as Japan. "Sustained deflation can be highly destructive to a modern economy and should be strongly resisted," he said.
Mr Bernanke then said that the Fed should maintain a safe "buffer zone" of 1pc to 3pc inflation to protect against shocks that could push the economy into a deflation vice. The chances of this happening are "remote indeed", he assured us, because the Fed would deploy all means to prevent it ever happening. "The US government has a technology, called a printing press [or, today, its electronic equivalent], that allows it to produce as many US dollars as it wishes at essentially no cost."
Does Mr Bernanke's pledge still hold, now that he is talking down the relevance of PCE inflation at 0.7pc? Or has he taken to heart warnings from ex-governor Frederic Mishkin that the Fed itself risks becoming trapped if QE continues into 2014? Has he buckled to pressure from his own Advisory Council, who now warn that QE is doing more harm than good? Has he simply been outnumbered?
The Left-Keynesians are furious - "A grave error of policy," said Berkeley professor Brad De Long - but so too are the monetarists, usually linked to the free-market Right.
US monetarist David Glasner says the Fed risks a "reprise of 1937", an episode largely forgotten because the re-armament spending soon came to the rescue. Industrial output fell 30pc to 40pc, back to the levels of late 1933. The peak to trough contraction in GDP was 11pc. Unemployment jumped to 19pc.
The Fed Minutes of 1937 are worth reading, a window into error as it unfolded. As late as June that year the Fed still thought "there was little evidence at the present time of a recession, and that it was the general expectation that in any event recovery would be resumed by Fall [Autumn]".
But then again, the Fed Minutes in the Spring of 2008 were no better. Then too they were talking tough - enough to push up long rates by 50 basis points - even though we now know that the US was already in deep recession. Robert Hetzel from the Richmond Fed says in his bookThe Great Recession that the FOMC's refusal to respond to a collapse in the money supply led directly to the Fannie, Freddie, Lehman, AIG disaster that followed.
But if the Fed has erred again this time, it can't hold a candle to the Bank for International Settlements (BIS). This club of central bankers - now entirely in thrall to the Bundesbank, and the liquidationist doctrines of the Chicago Fed circa 1931 - demanded a halt to QE this week, as well as rate rises, yet more fiscal tightening, and an even faster pace of credit deleveraging for good measure.
The American Nobel fraternity likes to accuse our own George Osborne of holding such views. This is calumny. Britain's fiscal tightening is a calibrated 1pc of GDP each year, and it is offset by £375bn of QE. The Osborne view and the BIS view have nothing in common.
One thing is certain, if such a nihilist cocktail of BIS contraction were imposed on the world in its current condition, it would kill recovery altogether, throw millions more out of work, and probably extinguish a few democracies along the way. Hungary is half gone already.
It would cause debt trajectories to explode, and therefore prove self-defeating on its own terms. The ultimate outcome would be a chain of sovereign defaults and bank crashes. This is one way to achieve a cathartic debt jubilee and wipe the slate clean, I suppose, but by stone age methods, with stone age results. The US whittled down the debt burdens left from the Second World War (120pc) by gentler means, and so did the UK (200pc).
The BIS is, of course, right to warn that QE as currently implemented is fuelling asset bubbles, with junk bond yields falling to record lows, and a new rush into "covenant lite" debt for leveraged buy-outs. But it recoils from the awful implication of its analysis - awful for the BIS and central banks, that is - which is that other forms of QE should be found to inject stimulus directly into the veins of the economy, such as building roads or nuclear power stations.
Takahashi Korekiyo pursued just such a radical expirement in the early 1930s, turning the Bank of Japan into an arm of the treasury and forcing it to fund government spending until the economy was on its feet again. It worked like a charm. Neville Chamberlain tried a lesser variant in Britain, with success. The US Treasury took over the Fed in the 1940s.
Lord Turner, former head of the defunct Financial Services Authority, proposes such a plan today, should recovery falter. His softer version would preserve the independence of the Bank of England, allowing it to decide the right level of fiscal financing.
This is complex territory, and may prove an idle debate if the US does indeed achieve the Holy Grail of "escape velocity". But if it doesn't, and if the reason for abjuring low-inflation monetary stimulus is because it causes dangerous asset bubbles, then for goodness sake do it without causing asset bubbles. Little is beyond the wit of man. Unless you are a defeatist.