Inflation, Deflation, and Putting
Since there is no data of note for a little while, there are some other topics I suppose I have time to remark upon.
I recently read a piece by Morgan Stanley called “Of Dogs, Deflation and Inflation.” In it, the authors essentially argue that the relative stasis of inflation recently is “best interpreted as a balance between inflation and deflation rather than concluding that neither is a material risk. While bold central bank action has been successful in stabilising inflation over the past five years, it has also increased the two-way risk to the future price level – both longer-term inflation and deflation risks have increased.”
If I see a photograph of a golf ball sitting on the rim of the cup, I might conceive of several reasons for that configuration. One is that there are no important forces acting on the ball, so it is sitting still on the edge of the cup. Another is that there are massive forces that are all canceling out: say, a strong wind blowing from right to left, and the golfer using a huge club rather than a putter to put the ball from left to right. Which of these two is inherently more likely? Is it possible that inflation has been relatively stable around the Fed’s target (using Median CPI) because massive quantitative easing just happened to exactly cancel the deflationary forces of the credit collapse? Well, of course it is possible. It is also possible that a derivatives book with two hundred trades in it just happens to have no risk at all. But when you are talking large numbers, it takes extreme precision to balance a system.
So it is more likely that neither force was very strong. However, there is yet a third explanation for that photograph, and that is that the ball was actually in motion and the picture just happens to capture a moment in time. The ball, in fact, proceeded to fall into the cup, but we don’t know that because the picture doesn’t tell us what came after.
This is the situation I believe we are in with inflation in the aftermath of the great recession. There is no doubt that the Fed’s aggressive easing helped ameliorate the deflationary pressures, although I think they were never as great as we thought at the time since the main deflationary pressure came from the decline in money velocity…which was caused mainly by a Fed-induced decline in interest rates. But these two forces, Fed easing and the deflationary impulses from a credit crunch, don’t act simultaneously. The Fed’s action takes longer to materialize in inflationary outcomes…especially when, as in this case, most of the easing from QE was sequestered in sterile bank reserves. We have, though, seen what is happening in the housing market, and it is foolishness to think that this has anything to do with strong household incomes or Congressional support for housing. It is plainly the result of a higher float of money, which has manifested in higher prices for real assets. And that putt was set in motion not this year, but with the earliest QEs that pushed money growth over 10% at times over the years since 2008.
Don’t look at the current state of the ball, that is core inflation, as being a deterministic snapshot. There is a delay between monetary policy and inflation outcomes (the old rule of thumb was 9-12 months, but it was pretty flexible), and that delay is even longer this time around because of the excess-reserves issue. The ball is in motion, and my guess is that the Fed struck the putt too hard.