Monday, April 20, 2009

Feldstein Warns on Inflation

Another mainstream economist is concerned about future inflation.

Martin Feldstein is currently the George F. Baker Professor of Economics at Harvard University, and the president and CEO of the National Bureau of Economic Research. From 1982 to 1984, Feldstein served as chairman of the Council of Economic Advisers and as chief economic advisor to President Ronald Reagan.

Feldstein has been a long time deficit hawk. His insider credentials also include membership in the Group of 30 and he was on the Board of Directors of AIG. Larry Summers was a student of his.

Unlike his Harvard colleague Greg Mankiw, who recently called for even more inflation, Feldstein knows there is already plenty headed our way. In an Op-Ed in today's FT, Feldstein writes:

The US last week showed its first signs of deflation for 55 years, prompting inevitable fears of further deflation in the future. Yet the primary reason for the negative rate of US inflation is the dramatic 30 per cent fall of commodity prices. That will not happen again. Moreover, excluding food and energy, consumer prices are up 1.8 per cent from a year ago. That is the good news: the outlook for the longer term is more ominous.

The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation. According to the Congressional Budget Office, the president’s budget implies a fiscal deficit of 13 per cent of gross domestic product in 2009 and nearly 10 per cent in 2010. Even with a strong economic recovery, the ratio of government debt to GDP would double to 80 per cent in the next 10 years.

There is ample historic evidence of the link between fiscal profligacy and subsequent inflation. But historic evidence and economic analysis also show that the inflationary effects can be avoided if the fiscal deficits are not accompanied by a sustained increase in the money supply and, more generally, by an easing of monetary conditions. the large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth. The broad money supply (M2) is already increasing at an annual rate of nearly 15 per cent. The excess reserves of the banking system have ballooned from less than $3bn a year ago to more than $700bn (€536bn, £474bn) now.
This is a decided change in view from Feldstein's opinion in October of last year, when I asked him about Federal Reserve money printing. Back then I wrote:

[Feldstein] said that money supply M2 was back growing at an annualized rate of 4.5%, which was correct. He said that this was about the correct growth rate given current GDP growth. This is a hoot, since money supply in September was at 1.5% annualized, and it then jumped to 2.3%, and now is at 4.5%, the Fed clearly has its foot on the monetary accelerator. I don't believe money supply at 4.5% is anything but a very brief transition point. Within weeks money supply growth could be at double digit rates. Indeed, the money supply numbers due out this Thursday could show M2 growth much higher than 4.5%. Feldstein clearly hasn't figured out that Ben Bernanke's Fed is clueless. When he does, I wonder what his prescription for the economy will be?
Now that money supply growth is well into double digits, we know what Feldstein will do. He has taken the responsible position and is opposing Bernanke's money printing.

He concludes with a very wise warning to bond holders:

It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.

1 comment:

  1. On the US long bond subject, look at last Wed's TIC data. Long term US Treasuries were net positive $21.6 B in Feb 09, up from $10.7 B in Jan 07 and $15.0 B in Dec 08. Of that, an astonishing $27.5 B was contributed by Japan to the net total (I stress net, which is why it is more than the total), up from $9.3 B and -0.7 B in Jan and Dec, respectively. This may explain the rise in the USD vs JPY in the critical early part of the year when it was teetering on support at the 87 area, subsequently rising to the 97 area by the end of February. Though the Bank of Japan had warned of possible direct currency intervention to aid its exports, on which its economy depends, the increased purchase of long bonds could have been the unannounced indirect method. This could also have been what kicked off the new Yen carry trade this year, with borrowers of the Yen investing in Aussie and Kiwi bonds. Chinese/Hong Kong purchases of long bonds have been tapering off, so once Japan is done depreciating, I would expect demand to falter for them and long term interest rates to rise significantly, even with Fed purchasing the long end of the yield curve. That is, unless the Treasury can find someone else to buy its debt. The timetable for this to play out is long term; however, it is something to monitor. With TIC data delayed 6 weeks, I'll be on the lookout for weakness in the USD/JPY cross combined with weakness in T-Bond futures.