Before 2008, the bubble that some economists expected to pop was the value of the dollar. Paul Krugman used a colorful metaphor to describe this.
So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar’s value doesn’t make sense, and that value plunges.
I found this in an old post from Mark Thoma. Feel free to use Google to find other citations.
Nowadays, when he looks at the prices of U.S. government bonds, Krugman sees rational expectations at work. He looks at the low long-term interest rates as a sign of the market’s wisdom in predicting low inflation for ten years.
But what I see is a market that could have a Wile E. Coyote moment. Once enough investors decide to dump our bonds, interest rates will rise. It will become clear that at those interest rates the government cannot afford to pay off the bonds, so more investors will dump bonds. etc.
Now the Fed can always buy our bonds. It is doing a lot of that, and I can see where an investor with a sufficiently short time horizon who believes that he won’t be the one still holding bonds when they start to lose value might say, “Don’t fight the Fed. Just ride the yield curve for a little while longer.”
But suppose that our Wile E. Coyote moment comes when inflation has been heating up. (Indeed, the Wile E. Coyote moment could come because inflation heats up, and at that point investors decide that the Fed may no longer be their friend.) Under this scenario, the Fed wants to be a bond seller, not a bond buyer, in order to keep inflation in check. If the Fed feels constrained not to sell too many bonds, then inflation could really take off.
How can I justify a fear of inflation, given recent behavior? In recent years, the Fed has created a lot of money, and we have not seen a lot of inflation. What is going on?
1. Perhaps money and inflation have no connection. We should go back to using the Phillips Curve. When unemployment is high, inflation is low, and conversely. After all, wages are 70 percent of costs, and it seems unlikely that wage inflation will get much traction with folks having a hard time finding jobs.
2. Perhaps we are suffering from tight money. This is the Scott Sumner argument. Money and inflation (he would prefer nominal GDP) are related, inflation is low, ergo we must have tight money.
For the short run, I believe something like (1). However, I am old enough to remember the 1970s. Based on that experience, I would say that inflation is subject to regime shifts. There is a regime in which inflation is low and relatively stable. There is another regime in which inflation is high and volatile. Finally, there is a regime of hyperinflation.
I think that with enough persistence, the Fed can move us between the low, stable regime and the high, volatile regime. The Fed spent the 1970’s getting us into the high, volatile regime, and it spent the 1980s getting us out of it.
Hyperinflation is a fiscal phenomenon. A government that can balance its budget is never going to have hyperinflation.
The scenario I have in mind is one in which the economy has begun to shift to the regime of high and volatile inflation. Then the Wile E. Coyote moment arrives, and the Fed feels pressed to keep the U.S. bond market “orderly” by not selling bonds. In fact, interest rates are rising so quickly that the Fed decides that it needs to buy bonds. This sets off a spiral of money-printing and price increases, threatening to bring on hyperinflation. In which case, the bond market will not be orderly. Nor will anything else.
When standing on top of a steep cliff, or on the roof of a high rise, mind tends to always entertain the idea of what happens if you fall. It is easy to skip the necessary step of actually having to jump or being pushed over the edge first. We are standing on a mountain of money, and most predictions of the eventaul demise just skip that critical step and say “when” (usually not even “if”) interest rates or inflation rise. What remains unexplored is what could compell self-interested agents to make the jump? The marginal act of selling a 10 year bond is equivalent to borrowing the same amount of money for 10 years. Does this perspective make the jump easier or hearder to imagine?
Unqualified thoughts by a non-economist.
After the Asian crisis of the late ’90s, I started reading that it had been caused by flows of hot money into Thailand and other nations: when those flows reversed, the nations couldn’t support their currency pegs to the dollar, and crisis followed. I had been surprised to read, though, that in several Asian countries, large increases in the money supply had not in fact caused consumer-price inflation; rather, the excess money had created asset bubbles. Various policies had allowed the governments to maintain the value of the baht (or whatever), but the prices of real estate and other assets had soared. So it looked as if there was no monetary inflation, but the inflation had in fact simply been redirected. The problem was that you generally can’t recognize this while you’re living through it. At that point it’s hard to say which assets, if any, are overpriced. How can you know for sure until some asset class begins to deflate? And it’s hard to know ahead of time what might trigger the collapse. But the main point is that large increases in the quantity of money do not automatically translate into inflation as measurable by consumer prices. The effects of those increases can be disguised for a long time. If you’re lucky, it ends in moderate inflation; if you’re unlucky, it brings on a crisis.
I suspect that we are living through another version of this right now in the U.S. Banks are holding onto excessive reserves, at least in part because the Fed is paying interest on them. There is a superabundance of money “in the system,” but we are not experiencing significant inflation. So we appear to have a contradiction–huge increases in the quantity of money, and simultaneously “tight money.” Both are true, and this worries me. It is not a “natural” occurrence in a healthy economy. And that’s why I think that the place where the inflation is being “hidden” (i.e., bank reserves) has to be functioning as a sort of bubble. QE has greatly increased the quantity of money, and it APPEARS that the money has maintained a more-or-less stable value. But the Inflation effect is merely being disguised, and the reserves themselves in fact are overvalued. That is, it is the assumed value of the reserves that has been inflated, even if inflation has not leaked out into consumer prices as a whole. As a result of QE, the dollar SEEMS stable and does not appear to have lost value as a result of the increase in supply, but in fact, once those reserves exit the banks, they will undermine the value of the currency at large and prove to have been merely a false store of value. There will be no way to exit this situation without triggering either inflation or crisis. I fear that this is not likely to end happily.
Do you think that the around four percent inflation of the eighties and the around two percent inflation of the aughts are coincidences? They both seem to feature low and stable inflation, but at different rates. What determines the rate in these situations? And how had so many central banks up until 2008 kept inflation so consistent at a specific number? Not trying to refute, just curious what accounts for specific inflation targets being met year after year in your description of a central bank.
Do you see your prediction as going against the market’s inflation expectations, as measured by the tips spread? Or is there some flaw in using the TIPS spread to measure market expectations of inflation? Or do you think the market is just wrong? Or are you thinking on a longer time line then the spread between, say, ten year notes (I know you say your thinking in terms of the long run, I just don’t know what the long run is)? Are you putting your money where your mouth is and increasing the mix of inflation protected securities in your portfolio?
I too am not playing gotcha. I’m not an economist and I’m genuinely curious how market measures of future inflation (which I’m sure I don’t understand fully) factor into your story. I asked the last question (“is this changing how you invest?”) because it’s something I’m always curious about when people predict that markets are wrong (if that is indeed what you are predicting).
As a completely different question, why do you think the fed will decide to buy bonds to keep rates low, inflation be damned, rather than just targeting inflation and letting congress deal with high rates by getting our fiscal house in order? I was 6 at the time, but my (wrong?) understanding is that when the yield on treasuries started to creep up in the 80’s and 90’s the fed did exactly that. It just seems weird to say “I anticipate the fed will completely shift from inflation targeting to targeting interest rates and a stable bond market, despite the fact that most economists think that would trigger a disaster in the face of rising inflation. Then I predict it will trigger a disaster in the face of rising inflation.”
I very much share your fears with regards to bonds.
Most economists assume that investors are holding US bonds for the interest; but in reality a large number are holding them for capital gains. Once the gains stop coming they will be gone.
Oh, and just to rub some salt in the wound, the decision to dump may well be taken by an algorithm – not a human being.
If we define money in such a way that the Fed controls it, is there a meaningful relationship between money and economic activity? If we define money in such a way that there is a relationship to economic activity can the fed control money? I contend that the answer to both questions was yes in the 70’s and no in the 10’s.
Financial intermediation creates economically meaningful money and most financial intermediation activity (aka banking) is outside the control of the fed. The fed can manipulate the relative competitiveness of the regulated commercial banking sector vis-a-vis the unregulated sector but only within narrow limits and certainly not enough to affect the economy. The exception would be a situation where the unregulated banking sector was rapidly contracting in which case the fed can mitigate economic contraction by buying assets that are being dumped. Essentially the fed can become another shadow bank to take up the slack.
So there is no longer any mechanism by which the fed can affect interest rates or inflation. Consider that global liquid assets exceed $50 T dollars. What possible effect can the fed converting T-bonds to interest bearing excess reserves at the rate of $50 B per month have on the economy?
Inflation will occur when dollar denominated US govt liabilities exceed the capacity of the US economy to support the debt. This, of course, depends on aggregate market perceptions that are inherently subjective judgments. But when and if the bondholders do try to exit the dollar simultaneously, look out. Until we reach that point Berrnanke can do what he likes, it will have no effect.
You have articulated what is known as Goodhart’s Law. I think it has some merit, but I would not carry it to extreme. If the Fed really wants to depreciate the dollar, it can.
Both 1. and 2. are wrong. The key factor you are missing is velocity. In a recession, that we’re only digging our way out of now, excess money won’t necessarily cause inflation, because expectations are low. Nobody knows how to put that extra money to good use. Also, the excess money is being held as electronic reserves at the Fed, which Bernanke is careful to keep there so that it doesn’t get into the broader economy, hence paying interest on reserves. The point you and most are missing is that the current moves by the Fed are not monetary in nature. They are merely creating electronic reserves in order to execute fiscal policy, not monetary policy. You have to look at the asset side of the balance sheet, not liabilities. The goal is to buy up tons of MBSs and treasuries in order to prop up those markets.
The Fed executing these moves, as opposed to the Treasury, takes political pressure off the govt for picking winners and losers, but since all profits and losses at the Fed go to the Treasury, it is effectively government policy. I think the Fed is taking on great risks for little gain, as I’m highly skeptical that buying all these securities moves the market much in recessionary times like these. And the risk is significant, ie the market picks up and the Fed can’t pull the money out fast enough. However, as long as Bernanke is in charge, I’m not worried about inflation: he’s not dumb enough to not pull the money out. The most likely scenario is default, the govt just cannot pay back its liabilities and will default on its mountains of debt.