St. Bernanke's Fight Against the Deflation Dragon
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According to legend, the town of Silene had a pond as large as a lake, where dwelt a plague-bearing dragon that envenomed all the countryside. To appease the dragon, the townspeople would feed it two sheep every day, and when the sheep failed, they fed it their children, chosen by lottery. It happened that the lot fell on the king's daughter. The king, distraught with grief, told the people that they could have all his gold and silver and half of his kingdom if his daughter were spared. The people refused. The daughter was sent out to the lake, decked out as a bride, to be fed to the dragon.
Saint George by chance rode past the lake. The princess, trembling, sought to send him away, but George vowed to remain. The dragon rose out of the lake while they were conversing. Saint George fortified himself with the sign of the cross and charged the fierce beast on horseback with his lance. He thrust the lance deep into the dragon, giving it a grievous wound.
The "dragon of deflation" today strikes fear in the hearts of both Fed official and economist alike while the townspeople struggle with its ramifications. Deflation, as an economic pressure, is very dangerous, and once entrenched is difficult to break. For the Fed the fear of inflation is far less worrisome than the concerns of a severe deflationary bout in the economy. This is why the current Administration has continued to feed the dragon with no apparent success in appeasing its voracious appetite.
However, even as I write this, I can hear the screams from the masses that hyperinflation is all but around the corner due to the deficits, a fiat currency and expanding debt levels. It is likely that the inflation will show up in the future, and it could be a far stronger pace of inflation than we are currently imagining. But for today, and most likely over the next few years, that is likely not to be the case.
In "Hyperinflation Is Not A Threat" we laid out the frame work that inflation is built upon rising wages, increased monetary velocity and rising commodity prices. Hyperinflation, on the other hand, is caused by a complete loss of faith in a currency from the threat of losing a war (Weimer Republic), an economic collapse or some other catastrophic event.
Even with all of our economic ills and woes, the U.S. is still the safest place, in terms of liquidity, depth and strength, to store excess reserves. The historic low yield on government treasuries is clear evidence that hyperinflation is not a threat. Unfortunately, for Ben Bernanke and the Administration, inflationary pressures are not evident either. The reason that I say "unfortunately" is that inflationary pressures are a sign that the economy is gaining strength. For all the money that has been spent trying to ignite the engine of economic growth, it has all remained a futile effort at this point. But are we slowly winning the fight against the dragon?
Let's start with the velocity of money. The velocity of money is defined by Wikipedia as "the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply." As the velocity of money increases, inflationary pressures are increased as demand rises. However, as you can clearly see, the demand for money has been on the decline since the turn of the century. The velocity of money did increase, as expected, during the economic recovery following the 2001-2002 recession. The moderate increase in velocity really coincided with the economy's "jobless recovery" but collapsed again during the financial crisis.
Even with all the financial stimulation from bailouts, to QE programs, tax incentives and credits, etc., the velocity of money has waned since the end of the last recession as the economy has sputtered along at sub-par growth rates. Of course, much of that can be attributed to sustained levels of high unemployment which has suppressed both wage growth and aggregate end demand which in turn has kept businesses on the defensive.
Wages are a critical weapon in defeating the dragon of deflation. Wages have remained not only in a long term downtrend but have also lagged the pace of inflation over time. The median wage level today in the U.S., had it kept pace with inflation, should be closer to $90,000 annually versus $50,000 today. This suppression of wages due to rising productivity levels, and now a large and available labor pool, contributes to the lack of aggregate end demand. The deflationary pressures of declining wage growth remain a major level of concern as the disparity between rich and poor continues to grow.
The problem with wage deflation for Bernanke is that in order for wage growth to occur he needs to fulfill his mandate of full employment. As the supply of labor shrinks the demand for increases in wages can occur. Benanke's real problem is the uncounted masses of individuals that reside in the population today. While the current unemployment rate has been declining due to a shrinking labor force the battle for Bernanke going forward is creating "real" full employment versus a "statistical" full employment level. While it is expected that millions of individuals will retire in the coming years ahead; the reality is that many of those "potential" retirees will continue to work throughout their retirement which will inflate the labor pool and keep a lid on future wage growth.
The only real inflationary pressures that we have witnessed in the economy since the turn of the century were in two primary areas - housing and commodities. The inflation that was in housing has now become a massive deflationary pressure on the economy. For all the hopes and hype about a real estate recovery being just around the corner; the truth is that while housing may be near a bottom - the dynamics of the economy, wages, supply vs. demand and interest rates (should they begin to rise for any reason) will hamper any recovery for many years to come.
Commodities, for most individuals, are the clearest and most prevalent indication of inflation. The average American witnesses it every day from the cost of food, clothing, gasoline, energy and utility costs. Commodity based inflation, since the recession ended, has been driven by the stimulative efforts of Bernanke's two quantitative easing programs. Bernanke's "lance" of QE was aimed at the very heart of the deflationary problem trying to stimulate a "wealth effect" to get the consumer moving again which would then hopefully spiral out into economic growth. The backlash from mainstreet America was quick as oil, food and gasoline prices spiked higher. Unfortunately, the inflationary pressures of prices didn't translate into any significant pickup in employment or the economy.
While Bernanke's efforts created a short term wealth effect in the stock market the excess reserves created by the QE programs remained bottled up at the banks rather than flowing through the system. Before the 2008 financial crisis, excess bank reserves remained constant going back to 1980 averaging just $18.9 billion. As of the end of the 1st quarter of 2012 excess reserves have remained near their record level of $1.58 Trillion.
Bernanke's battle continues as the inflationary effects of monetary policies are quenched by the tsunami of deflationary forces currently weighing on the economy. The threat of a deflation, three years after the last recession, remains an imminent threat. Like St. George, Bernanke is trying to slay the dragon of deflation but his lance of monetary policy has continued to miss its mark.
For Bernanke another round of QE is inevitable. As "Operation Twist" ends the economy, employment and the markets have begun to show cracks as they have each time stimulative efforts by the Federal Reserve have come to an end. The problem for Bernanke is that despite calls for assistance in policy efforts to promote economic growth from the current Administration - Congress and Senante have remained deadlocked in dispute blocking any potential actions. This has left Bernanke standing alone, facing the dragon, knowing that these programs have little long term effect. Each previous attempt to slay the beast has had a diminishing rate of return and a negative impact on the consumer. Lower rates have failed to spur demand for borrowing, expansion or increased employment. Today, with rates currently at historic lows, it is highly doubtful that dropping them from 1.6% to 1.5% or even 1.4%, will be the level that sparks the economic expansion.
The Federal Reserve, alone at the moment in this battle, really has no choice but to continue the fight. Without further supporting efforts the economy will be in a recession by the end of the year. With the Eurozone already leading the way the drag on the already weak U.S. economy will be untenable. It is not just the expanding crisis in the Eurozone that will rock the U.S. economy as it faces another debt ceiling debate, weakness in China continuing to emerge, the approaching "fiscal cliff," and weak consumption.
Will the Fed engage in another round of Q.E? I don't see where the Federal Reserve really has much of a choice and will only serve to stave off the inevitable for a while longer. However, for Bernanke, who is caught between an weak economy and an Administration in gridlock, it is time to drop the visor, hoist the lance to once again leap into battle. Ootherwise, the dragon will most assuredly feast upon the fair young maiden.
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