Notes on the Economy – 12/25/10

Ben, be careful what you ask Santa for

(or “Are current low inflation rates structural, posing a risk of deflation, or cyclical, and about to reverse without a boost from QE2?)

Although not “official official”, it appears that the FOMC has adopted a policy goal of 2% inflation, characterized by one member as “price stability”.  Must be from a new Fed dictionary as it sounds like changing prices to me.  A 10 year Treasury bond will lose 20% of its real value by the time it matures.  Somehow, that doesn’t seem like a good outcome.  Indeed, to average 2%, we’ll need higher inflation in the coming months.  Will higher inflation be justified as consistent with price stability as the Fed brings the “average” inflation rate up to 2% (over what period?  Not mentioned).  QE2 is supposed to enable this higher rate of inflation even as it is supposed to lower long-term interest rates (a contradiction?  It’s all about having the right “timing”).

For those worried about the potential for future inflation that could be fueled by over $1.2 trillion in Excess Reserves being held at the Fed, Chairman Bernanke commented on 60 Minutes that he can raise interest rates in 15 minutes (I assume that this would be the Federal Funds target rate since markets have a say in the determination of market rates on the yield curve as the recent experience has illustrated).   Unfortunately, interest rates are not the only variable in the inflation equation.  Indeed, longer term interest rates are driven by expectations of future inflation.  Inflation is a complex process as is the determination of interest rates as the increase in longer term interest rates after the start of QE2 illustrates.  QE2 was supposed to lower rates, but it isn’t that simple.

Once an inflationary process is triggered, it acquires a life of its own, driven by a host of structural and expectations variables.  The Federal Funds rate can be changed in 15 minutes, but as our experience in the early 1980s makes clear, inflation cannot be “turned off” as quickly.  To “retrieve” a trillion in excess reserves, the Fed would have to sell a trillion dollars worth of the assets it has purchased into financial markets.  Markets will determine the prices paid for these assets, not the Fed, and this will determine the course of interest rates and private capital flows (internationally).

The preoccupation with “deflation” seems a bit extreme in light of our history and in light of our most recent experience.  Severe price cutting was made essential by the sudden lurch of private spending to the downside (triggered in part by official declarations that we were on the verge of a depression).  This left firms with inventories that were geared to spending by a consumer that was not saving.  When the saving rate suddenly surged late in 2008, consumption spending crashed (each point in the saving rate implied a reduction of $100 billion in consumption spending) and firms had to reduce inventories with a vengeance.  This was accomplished by wide-spread price cutting.  However, assuming that this would continue indefinitely even after inventories were re-balanced (i.e. “deflation”) seems like a stretch. 

The end of this “disinflationary” episode is clear in the surveys conducted by the National Federation of Independent Business of its approximately 400,000 member firms.  In just 6 months, the percent of owners cutting average selling prices tripled from 11% in 2008Q3 to 34% in 2009Q2, retreating to 20% in November, 2010 and likely headed back to normal (around 10%).  Over the same period, reports of higher average selling prices fell from 42% of the owners to 14%.  The net percent raising prices fell from 32% to a low of     -24%, and has now risen to -4% on its way to positive territory.  The net percent planning to raise average selling prices has risen from 0% in 2009 to 13% in November.  More of these will “stick” as the economy improves. Deflation, or price behavior that would be expected in a business cycle adjustment that required heavy liquidation of inventories?  The Fed has made its call, you decide. 


Promises, promises and distortions

“PAYGO?  Gone.  No increase in the deficit?  Right!  An unemployment rate no higher than 8%?  How about 10%.  Keep your doctor and health insurance?  The list of promises is long but the list of promises kept very short.  But the size of government and the deficits that result from implementing programs that are supposed to keep promises but are not paid for or are poorly constructed continues to grow.

And, the “devil is in the details” as always. A promise to “reform healthcare” can leave the system in worse shape if it is not properly thought out and implemented.  “Tax reform” has become a joke that no one takes seriously when promised by a politician.

Promises by government to “create jobs” may sound good, but who can create jobs better, government pursuing the goals of politicians, most of whom had little or no real world experience, or private firms who seek to produce goods and services that consumers want?  As government takes more (in taxes and borrowing), the private sector has less to work with.

The “Bush Tax CUTS” debate is a clear example of the obfuscation of the issues.  We have politicians saying we must raise taxes to support what government is doing but not asking if what government is doing is appropriate or helpful.  The tax rates currently in place have been there for 10 years.  Now, continuing these is labeled as a “tax cut” for the rich, giving billions those who don’t “need” it (as if their incomes were not theirs to begin with!) .  We are told how much larger the deficit will be if we “give the rich a tax cut”, but  Democrats have been able to raise taxes on the rich for two years now with their super majorities, why didn’t they act if that was the best way to lower the deficit?  Why is NOT increasing taxes a “tax cut”?  How about “for every dollar we give the rich (give??, didn’t those “richies” earn it?) they only give back 30 cents” meaning of course that they save a lot.  So, the only good citizens are ones that spend all their money and save none (like for retirement or make funds available for investment)?  Ever get a loan from a bank with no savings deposits?  We save so little now that we have to borrow trillions of savings from other countries and run huge fiscal and trade deficits.  Is that good?

How about ethanol.  Because of the government mandates, we over-invested in corn-ethanol production capacity and distorted corn prices and crop planting decisions.  Now, ethanol companies are going bankrupt.  Congressional response?  Mandate higher ethanol mixtures for our gas to save failing firms, even though this is not the best for our engines.  And we now know it takes a “gallon” of fossil fuel to make a gallon of ethanol, a losing  proposition for air quality.  Of course we have an import tax on cheaper South American ethanol to protect our less efficient producers and we have a subsidy for domestic production.  As a result, our trading partners are complaining about the growing volume of exports of ethanol from the U.S., subsidized by taxpayers to the tune of 45 cents a gallon.  How much more of a mess can Congress make of it?  Stay tuned.  Congress is moving on, leaving their bad past legislation to continue to drag down our potential and misallocate our resources.  Bummer.