Casey Research economist Terry Coxon, Interviewed by Louis James, Editor, International Speculator
L: Terry, when I asked Doug about the ongoing battle between those predicting inflation and those predicting deflation, he said he relied heavily on your judgment on these matters. That makes sense, since you literally wrote the book on inflation-proofing investments. So, can you explain in simple terms why Casey Research expects inflation? With some prices falling, it must seem to many that we’re simply off our rockers…Coxon: We might have something that looks like deflation for a while, but inflation will win out in the end. It’s like being in a game in which one side always has one more move, until it finally wins. The government’s response to any whiff of deflation would be a restart of rapid growth of the money supply. That growth would be just as vigorous as the feared deflation seemed to be. The Federal Reserve would just keep piling on the cash, until deflation lost.
L: And presumably, with the government creating massive amounts of monetary inflation, masked by a period of average price deflation, by the time they realize they’ve gone too far, they will have gone way, way too far.
Coxon: That’s right. Administering monetary policy is like driving a bumper car, in which the feedback is very slow and has a lot of noise in it. At any given moment, the Federal Reserve – or any other monetary authority – doesn’t really know what the demand for cash is. They can only guess. If they are worried about deflation, they guess on the high side, creating more cash to satisfy what they think the demand for money is. If they overdo it, or if they underdo it, they won’t know they’ve gone too far for months, maybe years.
In running a central bank, there is a long time delay in seeing the results of what you’ve done. Milton Friedman’s famous expression was: “The lags in the effects of changes in the money supply are long and variable.”
L: Indeed. Let’s be clear here: when we talk about changing the money supply, are we talking about printing paper notes, are we talking about electronic ledger entries, are we talking about changing interest rates that govern multiplier effects, or some or all of the above?
Coxon: Two out of three. The mechanism is that the Federal Reserve purchases something. It’s usually the Federal Reserve Bank of New York that does the chore. What they most commonly buy is U.S. Treasury securities. In the last go-around, they bought a lot of other things, particularly a lot of junk debt, which is of grave concern to many, but is immaterial to the effect on changing the money supply. It’s how they pay for it that expands the money supply, and they pay for it by crediting the seller’s account at one of the banks maintained by the Federal Reserve. That makes more cash available to the seller’s bank. If the ultimate seller is a commercial bank, then it has more cash available to it.
L: Why does it matter if the seller is a commercial bank?
Coxon: Because the seller’s response to having more cash varies. Until the end of 2008, the result was pretty clear and straightforward. If the seller was a commercial bank, it would have more reserves than it was required to have, so it would lend or spend that extra cash, and keep doing so until it no longer had excess reserves. Under the rules that went into effect at the end of 2008, the Federal Reserve started paying interest on deposits that commercial banks have with Federal Reserve banks. They set the rates sufficiently high compared to what’s available on the money markets, so that the commercial banks are leaving their excess reserves on deposit, rather than redeploying them. Sellers other than commercial banks are not eligible to receive such interest payments, so they do redeploy the cash they get from sales to the Federal Reserve.
L: Hm. But why would the Fed do that? If the purpose of the bailouts was to increase liquidity in the markets and get the banks lending again, why would they pay the banks to leave their excess reserves on deposit with the Fed?
Coxon: Well, the operations that began in late 2008 have about doubled the monetary base. It was very roughly a trillion dollars. Nothing like that had ever happened before. Most of the new cash went to buy troubled assets from commercial banks. The first goal was to prevent the commercial banks from collapsing. If the Federal Reserve had done nothing else, the result would have been a doubling of the money supply within a few months, and we would have had South-American-style price inflation.
L: So they changed the rules so they could create a huge amount of money to keep the banks open, while trying to avoid hyperinflation.
Coxon: Yes. The money supply grew by about 20%, which, I suppose, they thought would be enough. To keep it from growing any further, they started paying interest on excess reserves, effectively sequestering those excess reserves.
L: That’s a lot of sequestered cash. But the U.S. government has done more than directing or allowing the Fed to buy toxic paper. There’s cash for clunkers and all sorts of other insane ideas coming out of Washington, with Congress seemingly willing to spend “whatever it takes” to get Boobus americanus to imagine he’s rich enough to start spending again.
And yet, the average Joe in the street doesn’t see inflation. Life hasn’t really gotten any cheaper, but gas is still way below its previous $5 high-water mark. Joe is worried about losing his job, and cutting his expenses, which is price-deflationary. Why isn’t he seeing more inflation?
Coxon: Joe isn’t seeing inflation because, so far, the Federal Reserve has not allowed the money supply to grow enough to trigger inflation. You’re mixing apples and oranges when you talk about Congress and the Federal Reserve. All of the runaway deficit spending is not, in and of itself, inflationary. The government spending borrowed money does not increase the money supply – it doesn’t change the amount of cash people have.
L: Ah. You’re saying that out-of-control government spending isn’t inflationary, but sets the stage for future inflation, when money has to be created to pay the government’s debts?
Coxon: What it does is create a political motive and economic need for inflation. These huge deficits may have slowed the recession that began in 2008, but to keep the recession from worsening, the Federal Reserve will have to prevent interest rates from rising for months or years to come. And to do that, it will have to start printing money to buy up debt instruments whenever the economy starts recovering, to keep interest rates down to levels that will not choke off the recovery.
Read the rest here.
Excellent interview. Nevertheless, I believe it will be the citizenry who will basically move towards precious metals and (relatively stable) foreign exchange. During the 1923 Weimar inflation, many German citizens began to hold their cash balances in British Pounds in order to avoid holding balances in their own rapidly depreciating currency. The politicians will probably not look favorably on this, as flight to other media will hinder a government's ability to collect seigniorage through currency depreciation, thereby reducing its ability to contract the size of its debt in real terms.
ReplyDeleteHis views on deflation vs. deflation are spot-on. Currently, banks are more than happy to maintain their level of excess, despite the minimal level of interest paid on those reserves, due to the perceived risk of an additional double dip, low money market rates, and from regulatory pressure to keep loan loss reserves down. If you're a banker, the last thing regulators want to see you doing is loading up on inferior-risk-grade spec home developments and unleased commercial real estate developments. Low-grade commercial and industrial loans, though not in as bad shape as their real estate counterparts, are still under heavy scrutiny.
As he stated in the full message, although deflation may dominate nine innings, there will be a tenth and eleventh inning for inflation. Presently, the Fed is having an easy time sterilizing excess reserves due to continuing pressure in the private sector to deleverage and fear of a secondary recession.
However, when we get past the Bottom of the 9th, and interest rates start to increase, the Fed is going to have a hell of a time keeping all of those excess reserves sterilized. Banks (at least in normal times) would prefer to earn 20-30% ROE on a loan portfolio rather than the currently anemic rate on excess reserves. In order to avoid, as he says, a South-American style price inflation, the Fed will have to raise the rate paid on excess reserves relative to a level sufficient to exceed the spread between overall loan rates and the banks' cost of funds, or (pulling the emergency brake) raise the reserve ratio to a level sufficient to eliminate the high level of excess reserves.
In the first scenario, the higher interest rate on excess reserves would just mean that M0 would just begin to grow at an ever-increasing rate, creating a self-sustaining feedback loop. Voila, inflation.
On the other hand, the effects of the "nuclear" option of raising reserve ratios would be so dire (for all banks, but especially smaller community banks) as to be politically unfeasible.
Either way, we are cooked.