Dear Diary,
That we live in an age of man-made wonders is beyond dispute. Painless root canals. Tinder. Central bank price controls.
We were traveling hard over the last couple weeks. Somewhere along the way we picked up a cold, which dogged us from Vermont to Maryland’s Eastern Shore. But the security X-ray at Nashville International Airport seemed to finally knock it out.
Global stocks have lost more than $3 trillion of their value so far this month. But the authorities rushed to the rescue like a surgeon taking out a ruptured gallbladder.
As St. Louis Fed president James Bullard told Bloomberg TV (reprinted from yesterday’s Diary):
I also think that inflation expectations are dropping in the US. And that is something that a central bank cannot abide. We have to make sure that inflation and inflation expectations remain near our target.
And for that reason I think a reasonable response of the Fed in this situation would be to invoke the clause on the taper that said that the taper was data dependent. And we could go on pause on the taper at this juncture and wait until we see how the data shakes out into December. So… continue with QE at a very low level as we have it right now. And then assess our options going forward.
Perhaps some future generation of philosophers will understand it better. To us, it resides among the great mysteries… along with the virgin birth and Hillary’s front-runner status.
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Statistical Mirage
Bullard is worried about too little inflation. Instead of going up 2% a year – by the official tally – consumer prices are going up only 1.7% a year.
This missing 0.3% has stuck in his craw. It bugs him so much he wants to do something about it. Of course, simply calculating the CPI slightly differently could erase it. Or it could simply be ignored… since it is largely a statistical mirage, with no meaning in the real world.
It is like the early Christian scholars who argued over whether the host merely represented Christ… or was the flesh of the Redeemer Himself. Unable to resolve these issues by logic or argument, they often went to war.
And so it was that James Bullard declared war on the 0.3% inflation that he says is missing… and that he considers essential to a properly functioning economy.
Does that mean that an economy with a CPI of only 1.7% will necessarily underperform, leaving widows and orphans hungry and homeless?
Will investors be unwilling to back major capital improvements if they see the CPI falling 0.3% short of the Fed’s goal?
Will employers hesitate before putting up a “help wanted” ad… sensing a serious lack of inflation as a threat to their businesses and their livelihoods?
Laissez les Bons Temps Rouler!
Investors didn’t worry too much about Bullard’s words or their meaning. They interpreted this passage as though he had said, “Laissez les bons temps rouler!”
The Dow popped up 263 points on Friday.
But les bons temps were short-lived.
Boston Fed president Eric Rosengren said he would be “pretty comfortable” allowing QE to expire later this month as scheduled. And yesterday, the stock market rally sputtered; the Dow ended up only 19 points.
European Central Bank president Mario Draghi is wrestling with the same devil: low inflation. Says Draghi,
[I]f this period of low price inflation were to last for a prolonged time, the risk to price stability would increase.
What does that mean?
Let’s say inflation was running 1,000% a year. Would that be price stability?
Of course not. Price stability increases as the inflation rate approaches zero, not the other way around.
Draghi might have misspoken. More likely, and more disturbing, he believes what he says. He and Bullard – the high priests of the central bank cult – believe they have the right, and responsibility, to set prices wherever they want them.
All of which reminds us of an old Diary dictum:
The people who always insist that we follow their ideas are always the same people whose ideas are idiotic.
The Golden Anchor
We wonder what he would have thought of inflation expectations a century ago. Then there was neither consumer price inflation nor any expectation of it.
And yet the US economy expanded… absorbing millions of immigrants from Europe – with full employment and rising incomes for rich and poor.
On the evidence, the lack of inflation expectations was a big plus. Central bankers were not alarmed; it’s part of their job description.
Their duty was to maintain the stability of the US dollar. They did this in a simple and effective manner – by making sure it was linked to gold in an express and unchangeable way.
Gold was subject to inflation, too – big gold discoveries in South Africa and California added to the supply and boosted consumer prices in the mid-1800s. But then the market went to work – improving productivity and output, thereby increasing the supply of goods and services that money could buy.
Result: Consumer prices fell in the latter part of the 19th century.
Such was the golden anchor to which the dollar was tethered that, by 1914, the ship was back in the harbor it had left 100 years before – with the purchasing power of the greenback almost exactly what it had been in 1814.
Messrs. Draghi and Bullard can stop worrying.
Regards,
Bill
The Most Important Chart in Finance
This is the most important chart in finance right now:
Source: Bloomberg, Fulcrum Asset Management LLC
The workings of the inflation swap market are not important here. What’s important is investors’ expectations of euro-zone inflation are tanking.
The implication: Mario Draghi’s promise to save the euro has fallen flat. The European Central Bank is out of ammo in its fight to keep inflation “close to 2%.”
The worry: Because higher levels of inflation are needed to lighten euro-zone nations’ debt loads, this could trigger a rerun of the euro-zone debt crisis.
But this is not necessarily the apocalyptic event central bankers believe it to be.
There is a perfectly healthy reason why consumer prices should be falling: the big drop in crude oil prices.
Crude oil prices are down roughly 25% since last June – largely as a result of an increase in North American supply.
This is the opposite of what happened in the inflationary 1970s, when a supply crunch pushed up prices… and drove inflation higher.
Today, oil-importing nations will see the cost of oil drop… boosting the economy… and providing extra funds to service sovereign debt.
This helps explain why bond yields remain so low. Bond investors are counting on inflation levels to stay low for structural reasons… and they can rely on the positive oil shock to soften the blow of lower inflation levels to overly indebted governments.