Can you have too much of a good thing? And specifically, can targeting low inflation and stable prices create problems that are even larger than the ones a stable price policy is trying to avoid? Today we look at a very interesting set of ideas proposed by one William R. White of the Monetary and Economic Department of the Bank of International Settlements (BIS). The BIS can be understood to be a kind of a central banker's central bank. So when they talk about appropriate central bank policy, those of us much lower on the food chain should pay attention.
Let's look at one paragraph in particular, which I am sure will show up in bearish commentary all over the world:
"Should any or all of these series revert to their historical means, the sustainability of future global growth would also be open to question, perhaps leading to a deflationary rather than an inflationary outturn. To combine the two possibilities, the worst case scenario would be inflationary pressures, leading to a sharp tightening of policy, which in turn could precipitate a process of mean reversion in a number of markets simultaneously."
We will look at what he means later in the letter. This article was brought to my attention as a must read in an email by Paul McCulley. When Paul says something is a must read, it goes to the top of the stack. And after reviewing the work at length, I agree. Let me warn you, it is in small print and full of economic jargon; but White highlights a problem that we have visited before: specifically, will periods of price stability fostered in an era of monetary easing yield to episodes of boom-bust cycles, and are we close to an end game? Should central banks consider changing their policy of targeting just inflation? If I can translate economic language, an admittedly arcane form of communication, into English, it should make for an interesting letter. You can read it for yourself at http://www.bis.org/publ/work205.htm.
Cutting to the chase, White suggests that central banks need to reconsider the current policy of solely targeting inflation and look at the other factors, like asset bubbles, etc. White's suggestions sound suspiciously Austrian in context. (The Austrian School was founded on the work of Von Mises and later Hayek and others in Vienna. It is mostly favored by hard-money and libertarian advocates.) White actually does discuss the above policies in the context of the debate between Hayek and Keynes in the 1930s, in the following paragraph:
"... to encompass the debate which took place before the occurrence of the Keynesian revolution. The literature produced by the Austrian school of economics in the interwar period concluded that the Keynesian focus on aggregate measures in the economy, like the overall measure of inflation, provided an inadequate bellwether for identifying emerging macroeconomic problems.
"Rather, the Austrians focused on the impact of changes in relative prices leading to resource misallocations and subsequent economic crises. Moreover, this literature treated economic developments as part of dynamic processes in which past events had an influence on the future. The long run was not just a series of short runs. In our modern world, where journalists, politicians and other non-academic commentators constantly use such terms as "excessive", "unbalanced", and "unsustainable", these pre-Keynesian insights might still have a capacity to enlighten. In the more formal models used by academics, these concepts are rarely present, perhaps because they are so difficult to model quantitatively in the first place.
"A starting point for the analysis in this paper is the explicit recognition of an increasingly obvious fact. Under the joint influences of deregulation and technology, the global economic and financial system has undergone massive change in recent years. The liberalization of the real economy, in particular the re-entry into the global trading system of such giants as China and India and developments in the global financial system over the last twenty years, have profoundly changed how economic processes work. We are increasingly distant from the highly regulated period following the Great Depression and the Second World War, when our current policy frameworks were developed. Indeed, the structural landscape looks more and more like that seen in the 1920s and the decades prior to World War I. It would not seem implausible, in the light of all this underlying change, that our policy frameworks might also need revision."
Targeting Inflation May be Bad for your Economic Health
First, let's review the current state of thought in the mind of our central banker. As noted here before, there are two things central bankers do not like. The first is inflation. You only have to go back to the '70s to see why. Inflation destroys wealth, increases the instability in an economy, results in higher interest rates which destroys profits, and brings on price instability and recessions. Fighting inflation after it has reached uncomfortable levels is not fun. We had to go through two serious recessions in 1980 and 1982 in the initial effort, which lasted for over 20 years.
But it is my contention, and I think that you can draw the same conclusion from White's paper, that central bankers like deflation even less. Thus they go to great lengths to avoid even a whiff of deflation; and if they find themselves in deflation, they go to even greater lengths to get out of it, as in the case of Japan.
The famous "helicopter" speech of Fed chairman Ben Bernanke was given in response to concerns by the financial community that we could see the United States enter a period of deflation. Bernanke assured the economic forum at which he was speaking that the Fed could resort to "unconventional means" to avoid deflation. I have written at length about that speech in Bull's Eye Investing and in this column.
Thus, my contention that central bankers fear deflation more than inflation. They will allow a little inflation but will aggressively fight deflation whenever we merely get close to it.
White outlines current central bank thinking: First, central bank policy today has as its primary objective of monetary policy maintaining inflation at a low positive level. He explains, "Given the presumed lags in the effects of monetary policy, this implies targeting a forecast of inflation for two years ahead. In some jurisdictions this objective is publicly declared (as in 'inflation targeting'), whereas in others it is implicit in what the authorities both say and do."
"Second, the principal instrument for achieving the objective is use of the short-term policy rate under the direct influence of the central bank."
Third, and this is important: "...the forecast of future inflation, whose evolution guides the setting of the policy instrument, relies primarily on the influence of 'gaps' in the product and labor markets. Thus, estimates of capacity utilization and the natural rate of unemployment play a central role. The use of other indicators of future inflation, such as the rate of growth of monetary and credit aggregates, are sometimes referred to (especially in continental Europe), but still play essentially a secondary role.
"Fourth, asset prices are important only to the extent they exert pressure on 'gaps' and subsequent inflation. In any event, asset price 'misalignments' are difficult to identify and cannot be effectively resisted since this would require interest rate increases that would be destructive elsewhere in the economy. Conversely, any slowdown in economic activity associated with an asset price 'bust' can be effectively resisted through an easing of monetary policy. This could impart a degree of asymmetry to the conduct of domestic monetary policy in the face of such disturbances."
Now, that last sentence is the key. What White means by "asymmetry" is that central banks target an inflation rate, whether explicitly or implicitly (as in the case of the US Fed). They tolerate mild inflation (around 2%) but do not tolerate deflation. Indeed, when inflation gets "too low," is it did in 2002, they drop rates dramatically to avoid it, or pursue low rates and "quantitative easing" as they did in Japan in the early part of this decade, up until recently. (Quantitative easing means that central banks, when either in deflation or facing the potential, pump massive amounts of money into the system in an effort to spur inflation and return to normal growth.)
White would suggest that central banks allow a modest deflation of the good kind (more later) just as they allow for modest inflation. He contends that to do otherwise allows asset bubbles to build.
So, what happens is that the response of central banks to a slowdown is to ease monetary policy, as they did in 1998 or 2001 in the US, or in the '80s in Japan. This creates the conditions for a bubble of some asset price somewhere, because they do not correspondingly remove the easy money policy when growth is normal. Think of stocks and real estate in Japan in the late '80s, stocks in the late '90s in the US, and perhaps real estate in a number of countries this decade.
White argues that central banks respond to slowdowns with an easy monetary policy, but do not respond to asset bubbles, allowing them to develop, thus creating the conditions for future instability. Which of course the central banks of the world will respond to by even more easing of monetary conditions. It becomes a vicious cycle which builds up more imbalances.
Thus, by having as the sole target "price stability" or low inflation (which everyone agrees is a good thing) in a period of already low inflation allows central banks to have a policy which may be too easy and which may foster asset bubbles, which are inherently unstable. This even though Alan Greenspan argues that you cannot know something is an asset bubble until after it bursts!
The Status Quo Argument
Of course, White acknowledges there are arguments for the status quo. In short, it has more or less worked up until now. "In particular, with inflation low and stable, there has been no need for periodic episodes of sharp tightening of monetary policy with the associated risk of inadvertent recession."
Those arguing for the status quo suggest the increasing imbalances apparent in the financial markets are simply part of the learning curve and that progress is being made. Says White, "On the contrary, more complete financial markets will prove in the end to be both efficient and highly resistant to shocks. Not only do they allow the transfer of risk to those most capable of bearing it, but they also facilitate intertemporal income smoothing, which allows demand to be maintained even under stress. Indeed, when one considers the number of serious shocks to which the global economy and financial system have been subjected in recent years, that inherent resilience is already increasingly apparent."
By "intertemporal smoothing" he means that we, and much of the developed world, can easily borrow money on our houses or credit cards and keep the demand machine going. Of course, this means debt of all kind skyrockets. White argues later that this is not necessarily a good thing. But an easy monetary policy facilitates this.
"...Given how successful the combination of these policies proved to be in stabilizing output growth, the case for a change in the framework for conducting monetary policy would not seem obvious. Yet, going beyond what might seem obvious, other considerations must also be taken into account."
In other words, things might not be as stable as they appear. The stability of prices might breed the conditions for considerable instability. White notes numerous examples from history where that has indeed been the case. There are four separate problems that result from current policy. Let me see if I can paraphrase White.
If you only focus on inflation or price stability, any build-up of asset bubbles or imbalances will only be "fought" in periods of rising inflation. Periods of low inflation will allow for bubbles and imbalances to build if the central bank continues an easy monetary policy.
If you only respond to subsequent downturns with an easing of policy, then you either have to quickly take the easing policy off the table or risk further imbalances and perpetuating the cycle.
The next problem is the tricky one, and needs a set-up. In economic language, you can have a "positive supply shock." In English, this means production of widgets moves to China or Mexico and the cost of widgets goes down. Consumers would consider this to be a good thing. But to a central banker it can look like deflation. If they respond by an easy money policy, it can make the potential for an asset bubble even worse. What White argues (as does Dr. Gary Shilling in his book called Deflation) is that there is such a thing as "good" deflation, which results from productivity and competition,
Let's quote directly: "...the pursuit of similar policies [easing after a problem and remaining easy until the next problem] in successive financial cycles might, for an extended time, maintain output growth and price stability, but could also compound the underlying exposures."
It is this fourth point which is critical. White acknowledges that things have been more or less successful so far. But he questions whether given the current policy that such success is a given. [All emphasis is mine.]
"... whether growth will prove sustainable remains an open question. One possibility is that the cumulative monetary stimulation seen to date will eventually culminate in overt inflation. Recent sharp increases in energy and commodity prices could provide a foretaste of such an outcome. With the short-run Phillips curve [A graph that supposedly shows the relationship between inflation and unemployment] now seemingly flatter than before, reversing any shift upwards in inflationary expectations might be costly and necessitate a more significant tightening of monetary policy than is currently expected.
"Another effect of this cumulative stimulation has been an upward trend in household debt ratios in the United States and in many other countries, accompanied by a trend downward in national savings rates, both to new historical records most recently. In China, in contrast, domestic investment has been drifting up and now stands at a record high proportion of GDP. Moreover, in global asset markets, many risk premia have also descended to record lows even as house prices have risen to record highs. Global current account imbalances are also at unprecedented levels, with those countries having the largest external deficits generally exhibiting the largest internal imbalances as well.
"Should any or all of these series revert to their historical means, the sustainability of future global growth would also be open to question, perhaps leading to a deflationary rather than an inflationary outturn. To combine the two possibilities, the worst case scenario would be inflationary pressures, leading to a sharp tightening of policy, which in turn could precipitate a process of mean reversion in a number of markets simultaneously.
"A further problem arising from the conventional approach is that, as imbalances accumulate over time, the capacity of monetary policy to deal with them could also become progressively reduced. A combination of raising rates less in the booms than they are lowered in successive busts could eventually drive policy rates close to zero. Once at the zero lower bound, the Japanese experience indicates that the power of monetary policy to stimulate the economy is much reduced. Should the economy then turn down, with inflation initially at a very low level, the possibility then arises that a more disruptive form of deflation might emerge. Were that to happen, it has been suggested that an even more 'unconventional' monetary policy stance than that applied in Japan would be called for, with all its associated uncertainties. That this was the end point to which the conventional way of conducting policy almost led us would, in itself, seem a powerful argument for further refining the basic framework."
In essence, White is saying "Ben, if unconventional policies are required to avoid deflation, which everyone agrees would not be a good environment, shouldn't we change our policies to try and avoid such a scenario?"
Of course, central bankers would argue that it is very unlikely we will get there.
White argues that we need higher rates than currently thought in good times so that we can avoid the boom-bust cycles of asset bubbles. But he acknowledges that it will be a tough sell. How do you convince someone to take some pain today in the form of higher rates so that things will be smoother over the very long haul. He is calling for a policy which does not simply resist inflation but targets asset prices, so that excesses do not build up and we see, in the words of Ben Bernanke "... an unwelcome substantial fall in inflation." If the Fed decided to pursue a policy such as White suggests, there would be mobs of executives and investors looking for rope and tall trees whenever a central banker appeared in public.
The Muddle Through Economy, Part VII
Long-time readers know I think we are headed for a Muddle Through Economy. By that I mean a period of below-trend growth and potentially mild stagflation. While there is a possibility for White's worst case scenario, I do not think it likely. Rather, I think, as White implies, that a series of monetary easings will eventually result in either an asset bubble bursting and a recession, or a return of inflation, which will mean high rates and a probable follow-on recession. Either way we end up in essentially the same place. But the current game now looks like it can go on for a lot longer than I thought back in 2003.
If one buys White's argument, then the Fed should raise rates more than the market has now forecast. I do not think for a second that any Fed governor will suggest such a policy regime change. What I do think is that the Fed is now looking at every piece of data prior to each decision. I think one of the important pieces of data is the housing market. We saw surprisingly, even shockingly, strength in the new-home sales data this week. It will be interesting to see what the Fed does in June. If housing is still strong, I think there will be a bias to raise rates yet one more time. Stay tuned.
New York, Whistler, and Las Vegas
I will be a keynote speaker at a conference sponsored by the New York Mercantile Exchange on June 7 in New York www.nymex.com/realalpha.aspx. It is a one-day conference on finding "Real Alpha" about how alternative investments should be an integral part of institutional investment portfolios.
The next week I speak in Las Vegas at another industry conference, and then on to Canada and Whistler in British Columbia. More on those in later issues.
I must confess I have an emotional conflict of interest about speaking on June 7. That night is the opening of the NBA Finals and I just know my Mavericks are going to pull it out and win the current series against Steve Nash and the Phoenix Suns. I need to be courtside. Is it just me, or is this NBA play-off year more entertaining than it has been in years? So many games going down to the wire, with many series going back and forth.
It is time to hit the send button, as I need to get to the Mavericks-Suns game tonight. Last game was won by the team that had the ball last, which was unfortunately for Dallas fans the Suns. Maybe we can play some defense this game. Losing two at home would not be good. Have a great Memorial Day weekend,
You wondering how stable the Mavericks will be analyst,
