This is an excerpt of the April 2014 Longbrake Letter. To read the letter in its entirety, click here.
Now that economic expansion in the U.S. finally appears to be gaining traction and the Federal Reserve has begun the process of normalizing monetary policy by slowly reducing the quantity of large scale asset purchases, attention has turned toward whether renewed inflationary pressures might be just around the corner. But, some warn that the pending threat is not one of inflation but rather one of deflation.
With the exception of Japan, courtesy of Abenomics, global inflation rates are either stable at very low levels or are still declining. In the U.S., core PCE inflation has been stable between 1.1 percent and 1.2 percent for the last eleven months, while total PCE inflation has fallen to 0.9 percent. In Europe, total inflation continues to fall steadily and was 0.5 percent in March. Europe’s core inflation rate in March was 0.8 percent. Global inflation was relatively stable at a low 2.0 percent rate in February, reflecting modest downward pressure from some developed economies and an absence of upward pressures from emerging economies.
Conventional wisdom assumes that global growth will improve during 2014 and 2015 and that as that occurs output gaps will narrow and upward pressures on inflation will naturally emerge. But, the question is whether the conventional wisdom is right or whether other forces are at work which threaten deflation, notwithstanding improvements in global growth.
Capitalism is inherently deflationary. That tendency is not fully appreciated because we have lived in an era marked by persistent inflation. The name of the game in capitalism is to produce more with less and to maximize profits, which creates unrelenting pressure to cut costs and to use inputs more efficiently. One need only study the causes of persistent deflation in the U.S. between the Civil War and World War I to understand how market-driven capitalism results in deflation.
Everyone is taught that inflation occurs when demand exceeds supply. But, in a market-based economic system relatively free of government and regulatory interference, supply tends to lead demand. So what is it that leads to self-sustaining inflation?
There are two sets of conditions that result in persistent inflation. The first set involves macroeconomic policies, both monetary and fiscal, driven by government and central banks. The second set involves how participants in an economy adjust behaviors to inflationary expectations. If one expects prices to rise tomorrow, then it is best to purchase goods and services today at lower prices. But, the very act of accelerating purchases increases demand relative to supply and the increase in prices becomes self-fulfilling. Of course, expectations can also reinforce deflation – postpone purchases today because prices will be lower tomorrow. Japan’s lost two decades of persistent deflation leave no doubt that expectations are a powerful reinforcer of trends in prices and can work in either the inflationary or deflationary direction.
Monetary policy’s impact on inflation is well understood. If there is too much money chasing too few goods and services, prices will rise. Of course, the opposite is also true. Part of the deflation problem of the late 19th century was that the money supply was tied to the stock of gold and the stock of gold did not grow sufficiently rapidly to facilitate the more rapid growth in economic activity.
In recent times global central banks have become generally paranoid about their role is fostering a self-sustaining inflationary process. For that reason, most have adopted specific inflation targets with 2 percent being the favorite target level. However, 2 percent is generally viewed as a ceiling, not as an average level to hit over the economic cycle. Some, such as Paul Krugman, question whether a 2 percent target, especially since policy treats it as a ceiling, provides a sufficient buffer to prevent unintended embedding of deflation.
When central banks are behaving and limiting inflationary pressures through monetary policy, inflationary pressures can still emerge through fiscal policy. Government policies intended to stimulate economic activity, particularly if they result in substantial debt creation, will stoke inflationary pressures. Debt creation can occur directly in the public sector but it can also occur in the private sector, as the recent U.S. housing bubble amply demonstrated, by virtue of specific government legislative and regulatory policies.
It is understood that debt creation can accelerate economic growth by boosting demand. That is what the Chinese miracle is all about. But, as Hyman Minsky pointed out, if debt growth is excessive it will result in nonproductive speculative activity, and in the extreme Ponzi financial activity, which, if left unchecked, will result in financial instability and an eventual painful correction.
There is a natural rate of growth in debt that is neither inflationary nor deflationary. This natural rate is a function of the natural rate of interest as the famous economist Knut Wicksell theorized. The natural rate of interest is that rate of interest at which intended investment and intended saving balance. The equilibrium natural rate of interest occurs at the rate that induces enough savings – supply of funds – to fund investments – demand for funds – whose expected returns exceed the equilibrium rate of interest. Since the natural rate of interest is not observable, actual decisions are based upon the market rate of interest. But, if the market rate of interest is different from the natural rate, some decisions will be “incorrect”. This initiates policy risk and its magnitude will depend on the size, direction, and persistence of the divergence between the natural and market rates of interest.
Debt will grow too rapidly if the market rate of interest is persistently less than the natural rate of interest. This will foster speculative activity rather than productive investments. Usually, this is thought to be a monetary phenomenon, not a fiscal policy driven one. However, fiscal policy can affect the natural rate of interest by increasing or decreasing investment activity. When there is a great deal of slack in an economy, governments can create investment initiatives with good rates of return that the private sector is unwilling to undertake. All else equal, this would soak up excess saving and lower the natural rate of interest. But not all government spending has equal value in terms of investment. If increased government spending goes into transfer payments, it boosts demand, not supply and contributes to inflationary pressures.
Governments can also create an inflationary bias by constraining competition. For example, rules intended to protect industries or workers or policies that subsidize demand for certain products can limit price competition and depress productivity. Implementation of economic reforms, whether it be Japan’s Abenomics third-arrow, China’s Third Plenum reforms, or Europe’s requirements for Greece, Spain, and Portugal, are intended to increase economic efficiency and boost productivity.