a bull flattening bias of the Treasury curve, with longer-dated rates falling toward the near-zero Fed policy rate, can be viewed as a consensus view that the level of the output/unemployment gap plumbed during the recession is so great that disinflationary forces in goods and services prices, and perhaps even more important, wages, will be in train, even if growth surprises on the upside.
Pointer from Tyler Cowen. Note that McCulley was the one who first made the joke several years ago that the Fed needed to create a housing bubble to replace the Dotcom bubble, a joke which was repeated by Paul Krugman.
So here is what the financial markets are thinking vs. what I am thinking:
Markets: With so much unemployment and excess capacity, we cannot possibly have inflation.
Kling: Do you not remember the 1970’s? Furthermore, you may be over-estimating the excess capacity. An excess capacity to sell houses and trade securitized debt may not help absorb demand in other sectors.
Markets: The Fed has no plan to raise interest rates. Therefore, interest rates cannot rise.
Kling: The Fed merely determines the composition of government debt. The amount of government debt is determined by fiscal policy, which the Fed does not control. At some point, the huge supply of government debt has to matter. If the public loses its appetite for government bonds, then the only way the Fed can absorb the supply is to print gobs and gobs of money. Prices will rise, and bond-holders will suffer a partial default in terms of purchasing power. Even if the Fed is relatively passive, I think that the high-inflation scenario is plausible.
Markets: I can hold bonds for now. If inflation threatens to come back, I will see it in plenty of time to get out.
Kling: That is how bubbles work. Everyone thinks that they have more protection from the bubble than they really have. Personally, in spite of the inflation bets in my portfolio, my big worry is that I do not have protection from the political risk and financial chaos that could come from a sovereign debt crisis.
READER COMMENTS
Joe Cushing
Nov 2 2009 at 9:45am
This is the first time I have read an economist make the obvious claim that government is our economy’s biggest threat right now. I’m glad you did. I think a lot of people can see this but to have an economist say it adds weight. It validates people’s perceptions.
I have a question.
Is it possible for the Fed to refuse to monetize debt the federal government cannot raise in the markets? Could the Fed say no to the treasury? After all, isn’t that why the Fed is separate from the government? What would happen in that situation? Could we reduce the size of government by the fact that it can’t get money to spend? It’s happening to Michigan. Our governor wants to spend but she can’t get money to do it. It’s the silver lining in the cloud over Michigan.
Lee Kelly
Nov 2 2009 at 11:33am
It seems to me the Fed can increase the demand for U.S. Government debt without actually buying anything; it merely needs to indicate an intention to by debt in an emergency and people will be more willing to hold it. In other words, if the Fed extends an implicit guarantee to bailout the U.S. Government, then bond holders will tolerate greater risk of default and rates of inflation than otherwise. Of course, such an act would be horribly inflationary, but such is the cycle of deficit, debt, and debasement.
Doc Merlin
Nov 2 2009 at 11:51am
I thought Krugman was being serious….
8
Nov 2 2009 at 11:57am
About the 1970s…is there a difference between the composition of the money supply in the 1970s (amount of physical currency in circulation) and the money supply today?
If the Treasury department were printing bills, there can be inflation with unemployment because the physical stock of money is growing relative to the total supply of goods and services.
I’ve looked at the printing, and while it is up, it is nowhere near as much as the expansion of the Fed’s balance sheet. The Fed is creating debt, not money. That debt can be repriced at any time, whereas physical currency endures.
Yancey Ward
Nov 2 2009 at 12:54pm
Personally, I don’t believe the central banks can refuse the politicians. The actual power arrangements simply don’t work that way.
However, rather than resort to outright monetization, a preliminary route to finance government debt will be to force everyone to invest in government debt to “fund their retirements”. Think of this as Social Security II. You got a 401K, you gotta convert it to government bonds. You got an IRA? Government bonds. You got a job? A new payroll surtax for retirement to be invested in government bonds. Of course, this has its limit in that, eventually, more and more someones start trying to sell these bonds for food, housing, and heat.
Simon K
Nov 2 2009 at 1:16pm
Seems to me the key question is just how much of the excess capacity is really in real estate, construction and fixed income trading, which everyone should agree need to shrink, and how much is elsewhere. To put it another way, how much of the decline is GDP is due to recalculation and how much is due to a drop in aggregate demand?
I don’t think its very likely that 10%, probably more, of the population were employed in industries so closely linked to real estate that they need to recalculate.
fundamentalist
Nov 2 2009 at 1:54pm
The “market” position is also the same as that of most CFA’s. Investors would do well to head Dr. Kling’s advice and ignore the CFA’s. Fat chance of that, though.
Lee Kelly
Nov 2 2009 at 1:55pm
Simon,
I don’t think it is just about how much excess capacity is in real estate, but the change in the composition of demand for other goods and services. When the money shifts away from those sectors and toward others, does it also end up in the hands of people with different demands? It seems to me that the distortions created by the bubble are likely to wriggle their way (albeit with diminishing importance) throughout the whole economy.
Anonymous Coward
Nov 2 2009 at 2:06pm
@Yancy
Thats how the actual Social Security trust fund works, the money is ‘invested’ in treasury bonds.
Marco
Nov 2 2009 at 3:41pm
The 70’s were also different from the perspective that we didn’t have as many imports from low priced countries (China), who are pegged to the dollar. Excess capacity in China results in decreasing cost of goods sold in the US, which in turn results in deflation.
Michael K
Nov 2 2009 at 4:13pm
If you think unemployment and under-utilized assets prevents inflation, visit Zimbabwe!
Inflation is always and everywhere a monetary problem
MK
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