Quantitative Easing

The figures keep coming in — and lately, as you may have noticed, they have not been looking too good. The chief problem seems to be that both consumers and producers are more interested in paying down debt than in expanding consumption or production. Some talk about double-dip recession. Some talk about deflation.

Ben Bernanke says the Fed has not exhausted its supply of tools for fighting such threats, but he has not been especially specific. Presumably he is referring to quantitative easing, a central bank policy that, essentially, creates a bit (hopefully only a bit) of inflation and makes the "security" of Treasury bonds less attractive by further lowering the already low rates of interest they currently pay.

The recent Fed announcement that proceeds from mortgage backed securities now beginning to bring in some earnings would be reinvested in Treasuries does not really count as quantitative easing, since it does not really increase the money supply. It suggested, though, that the Fed might be willing to purchase securities with newly created money — how much, or how soon, is anybody's guess.

There are a couple of problems, though, with quantitative easing. One is the possibility that it could stimulate inflation without prompting any increase in productive business activity. If that happened, prices would go up while unemployment stayed high — stagflation, seventies style — and people certainly would feel poorer. Those on fixed or limited incomes would be poorer.

More likely, though, it would accomplish nothing at all — the experience of the Bank of Japan when it used quantitative easing in an attempt to get Japan out of its "Lost Decade" of the nineties and the recession of 2000-2001. While a cheaper dollar ought to stimulate exports, it's just as likely to spark a trade war. Every country in the developed world is trying to export its way out of the current mess, and it's illogical to think they all could succeed.

I'm inclined to think the Fed really is out of ammo, so we're going to have to depend on Congress making intelligent fiscal policy. Since I'm not making predictions anymore, I'll let you decide for yourself how likely it is that that will happen.

Are you stimulated yet?

The Fed, apparently, believes we've been stimulated enough, and finally has ended it's orgy of rate cutting. A hint that interest rates might even be going up in the not too distant future was enough to panic the stock market into bear country, although word of more write-downs by major banks certainly contributed to that panic.

Consumer spending has been flat at best, despite $152,000,000,000 in stimulus checks -- and even the habitual optimists are expecting the current economic malaise to be with us for another three quarters. At the same time, higher rates of inflation are inevitable as ballooning energy costs are passed along by businesses to their customers. What's a Fed governor to do?

The answer, apparently, is to try to restrain inflation rather than trying to goose a little more life into a moribund economy. As we learned in the seventies, monetary policy is not particularly good for addressing stagflation, so you address the greater threat.

Yes, yes, I know! There's no wage-price spiral this time, so we won't be getting the double-digit inflation of the seventies, and so I shouldn't be characterizing the current mess as stagflation -- but what else do you call simultaneous recession and inflation? Ralph?

Whatever you call it, the pain is likely to be the same. In the seventies, at least the union workers -- the wage part of the wage-price spiral -- were managing to stay even. This time, the inflationary pressures won't come from wages, and the pain of higher prices may be distributed more equitably. After thirty years of contraction, the unions still with us don't have much bargaining power left. Lately, all labor seems able to do is trade wages and benefits for a little more job security -- then discover that the "job security" was an illusion all along.

Along with energy, the force driving inflation this time will be the futures markets -- not because "speculators" are out of control, but because investors are looking for safer places to put their money than the stock market. If somebody is willing to pay 75 bucks for a pork belly delivered in August, you can bet that come August bacon will cost more.

When the banks finally are finished writing down all the bad loans, and house prices have bottomed out, and the wave of personal and business bankruptcies subsides, things will get better. Higher interest rates and higher credit standards will restore some value to the dollar, and people will learn to get by on a lot less gasoline. Until then, we just have to ride it out.

Fodder from the Fed

So according to his testimony before Congress, Ben Bernanke seems to think that inflation -- currently greater than it's been for twenty-five years -- will somehow peter out in just a little while. He didn't say how that was going to happen, of course. Will demand for oil by China and India miraculously contract so as to reduce the price of a barrel of crude? Will agribusiness stop growing corn for highly profitable subsidized ethanol, put those fields back into wheat and soybean production, and bring down the price of food? Will the dollar suddenly start getting stronger, bringing down the price of imports?

I don't think so -- but I'm not a world-class economist and Chairman of the Federal Reserve Board. On the other hand, unlike Bernanke, I don't have to worry about my words having a chilling effect on the markets or on consumer confidence. Hardly anybody reads this blog, so I'm free to say what I believe without worrying about consequences.

Bernanke strongly suggested that we can expect more cuts in interest rates. That probably will make Wall Street speculators happy for a while, but the longer-term effects of further cuts are not likely to make the rest of us too happy. Even though the Fed slashed the federal funds rate by almost a third in January, consumer interest rates haven't declined at all. Some variable rate mortgages will reset at lower rates than they might have otherwise, but the rates for new fixed rate mortgages are still drifting upwards -- for the smaller numbers of families who actually can get new mortgages. Credit card rates are just as usurious as they were before the Fed actions.

In other words, the January rate cuts have done nothing to increase consumer spending, and so have done nothing to stimulate the economy. The main effect of further rate cuts by the Fed will be to further weaken the dollar -- and, by definition, a drop in the value of your money is inflation.

Now that the rest of the country has caught up with me and started talking about stagflation, lots of people (including Bernanke) are desperately denying the possibility that it ever could rear its dreaded head again. Of course, there still are plenty of people denying that we're in a recession too, and for very similar reasons. Formally, a recession is defined as two consecutive quarters of negative growth, so we won't officially know if we're in a recession now until the figures for both this quarter and the next are in, sometime around the end of August.

Clearly, if there's no recession, there can't be stagflation -- and anyway, many of the naysayers maintain, you have to have both economic stagnation and inflation for years before you can properly use the term stagflation.

Big deal. Call it what you will, we'll still have to contend with economic contraction, higher unemployment, and inflation at the same time. The Fed isn't very good at doing that, because it can't raise interest rates to counteract inflation at the same time it cuts them to counteract recession.

Dammit, we're going to have to look to Congress again! I'll describe some of the useful things Congress won't do in a later post.

Speaking of stagflation...

According to a front page article in the Wall Street Journal, I'm not the only one concerned about the threat of stagflation -- but I'm pleased to say I beat the WSJ to it by more than a month. (Check out my original post here, and next time, maybe you'll listen! ;-)

Mind you, I don't expect an exact repeat of the stagflation of the 1970s because I don't see much chance of a wage-price spiral. Back then, we still had unions capable of negotiating higher wages when prices went up. Just the same, keeping labor costs low won't necessarily hold inflation down -- not in a global economy where we are so heavily dependent on imports. Inflation in China is running at 7.5%, which will spill over into the cost of goods sold here, and the weakness of the dollar will continue to push up the prices of imported goods.

When higher production costs from rising commodity prices and lower demand due to recession combine to threaten CEO annual bonuses, the prices of many products will be increased just to maintain corporate profit margins -- and in industries where competition is limited, the trick will work. We'll still buy food and gasoline and electricity, and most of us will hang on to our cell phones, cable TV, and internet access.

Let's see what Ben Bernanke has to say next week.

The politics of stagflation

Yesterday we heard that the Producer Price Index (PPI), which measures inflation at the wholesale level, was up 6.3% for 2007. Today, we learned that the Consumer Price Index (CPI). which measures retail prices, was up 4.1% -- the largest increase since 1990, and up quite a bit from last year's 2.5%.

Driving those increases were sharp increases in commodity prices -- crude oil, of course, but also corn, soybeans, cattle, copper, uranium, and other raw materials needed for production. The increases are demand driven. Developing countries, especially China and India, are now in the market for products previously hogged up by the United States and Western Europe. As the Chinese and Indian economies continue to grow, competition -- and prices -- can only increase.

There are those, in government and the business community, whose rose-colored glasses seem to be affixed to their heads with nails driven through their frontal lobes. A few still say we can dodge the recession that already has started; others claim that a recession in the United States will halt the growth of commodity prices.

Sorry, but it ain't gonna happen. We're in for a rough ride.

When prices are going up and incomes are going down, both consumers and businesses suffer. In last few recessions, people maintained their standards of living by using credit. This time around, though, credit is tight. Lots of people already carry more debt than they can pay back, and banks finally are raising their lending standards to where they should have been all along.

As I explained a couple of posts ago, when you have inflation and recession at the same time, it's called stagflation -- and interest rate cuts by the Fed won't solve the problem. Lower interest rates, combined with our weak dollar, will just make it harder to attract the foreign capital we'll need to get the economy going again.

So if the Fed can't save us, who can?

Oh, crap. Looks like it's gonna have to be Congress. Oh, crap, crap, crap! But what, you ask, can Congress do?

A really great start would be removing the tariff on imported ethanol, currently 54 cents a gallon. Brazilian ethanol, made from sugar cane, would be cheaper than our own, which is made primarily from corn. There would be some impact on gasoline prices, but even more impact on the price of food.

Corn used for ethanol can't be used to feed animals, so meat, egg, and dairy prices have gone up sharply. As more agricultural land is used to grow corn for ethanol, there is less available to grow wheat and other grains, pushing food prices even higher. Also, let's not forget the cost of the corn sweeteners that add empty calories to so much of what we eat.

While it's eliminating the ethanol tariff, Congress also could switch the $2.5 billion subsidy paid for production of corn-based ethanol to more cost-efficient forms of alternative energy. Once food and energy prices drop, consumers will have more money to spend in other sectors of the economy. Wouldn't that be great?

It won't happen, of course, because the agribusiness lobby is just too strong, and some of our elected representatives are just too dependent on agribusiness money. Instead, we'll get a few tax cuts and a few spending programs, all targeted at recession rather than inflation, and all more cosmetic than functional.

And we'll all just tighten our belts and try to ride it out.

What's worse than a recession?

Yes, depression is worse, but not an immediate concern. We still have plenty to worry about, though.

Back in the seventies, we ran into an economic situation that broke the rules. It was so unprecedented that economists had to make up a new name for it: stagflation. Briefly, stagflation is what you get when the economy isn't growing and unemployment is up (recession), but prices continue to rise (inflation). It's the worst of both sides of the business cycle, rolled into one.

Economists still debate the specific mechanics of what happened, but all agree that rapidly increasing fuel prices played a major role. Higher energy costs are reflected not only in the prices of gasoline and heating oil, but in the price of food and virtually every other consumer good. It takes energy to produce and transport a product, and at least part of the costs of production must be passed along to the consumer.

If income had kept pace with price increases back then, inflation would have been the only problem, but that's not what happened. Faced with increased fuel costs while trying to remain competitive, many producers responded by cutting labor costs. As workers were laid off, demand dropped, putting more pressure on business.

According to classic economic theory, when demand drops, prices should drop as well -- but thanks to unprecedented cooperation among the OPEC states, fuel prices continued to rise. Producers in the United States responded in the only way they could: they pushed up product prices while continuing to lay off workers. Demand for goods and services continued to fall, but prices kept rising. High unemployment put downward pressure on wages, decreasing demand even more. Times were hard.

What saved us was the collapse of oil prices in 1982. Our slowing economy decreased demand for oil, and the OPEC oil cartel couldn't keep its act together. Various member states began selling more than their quotas to maintain their incomes; competition returned to the oil business, and the price of crude fell to less than half of what it was at its peak. The Reagan Administration claimed credit, of course.

There are clear similarities between 1973 and 2008. Adjusted for inflation, today's oil prices are higher than they were at their peak in 1982, and the dollar is weaker than it has been at any time since the 1970s. The sub-prime mortgage crisis and the immense increase in federal borrowing to finance high-end tax cuts and the war in Iraq have sharply reduced the availability of credit. Less credit means less demand for goods and services, which leads to less demand for labor, and higher unemployment. There is no indication that oil prices will drop sharply any time soon.

Fed Chairman Ben Bernanke, under considerable pressure from Wall Street, tells us to expect further cuts in the discount rate, but the threat of stagflation puts the Fed into a double-bind -- cutting interest rates can make the coming recession less onerous, but create inflationary pressures. Cutting interest rates also will put further downward pressure on the dollar, making all imports -- including oil -- more expensive.

It's also unlikely that rate cuts will be increase demand as much as they may have done before the credit crunch. Burned in the sub-prime meltdown, financial institutions are hesitant to offer consumer credit as readily as in the past, and consumers who can qualify are beginning to pay down their debt rather than make new purchases.

In other words, cutting rates might do more harm than good -- except, of course, for hedge fund managers and other financial services executives, who earn annual bonuses based on how well the market does. Rate cuts do tend to send stock prices higher, and we can't expect the richest individuals in the country to get by on just their seven-figure salaries, can we?