So Accrued Interest has settled it once and for all. Inflation risk is low. The Poll proves it!
As a final point on the inflation subject, I wanted to look forward, to the future, the horizon. Obviously the dire consumer situation isn’t going to last forever. Even though much of the wealth destruction I mentioned last week isn’t going to recover in a V-shape, we will reach some sort of equilibrium in housing eventually. Even given a L-shaped recovery in housing, consumers eventually get back on their feet. Maybe they can’t spend their home equity but they’ll still spend their earnings. We will also reach some sort of equilibrium in personal savings, which I think will wind up in some relatively low, but still elevated level.
So inflation isn’t dead. Not yet. And thus the Fed will eventually have to pull way back on its current policy accommodation. How and when will this happen, and what are the risks.
The biggest risk is Fed independence. You want to know what really worries me for the long-term? Fed independence.
I believe firmly that the men and women who are responsible for normal Fed policy actually learned the lessons of the 1970’s. That inflation is an insidious problem, and once it takes hold, its is painful to wrench out of the system. I realize many readers will disagree, given the aggressive policy of the last 12 months, but spend a day going back and reading Ben Bernanke’s old speeches, and I think you’ll agree. Policy of the last 12-18 months has been all about eliminating a Great Depression style debt deflation. Once that battle is won, I believe the Fed’s policy makers will want to wind down their non-traditional policy maneuvers.
There are those who say they can’t remove these policies in a timely manner. I don’t get this argument, as it seems to be merely based on the sheer size of the programs. Remember that inflation is a rate of change, therefore stock measures aren’t terribly relevant. Its all about marginal changes.
To see what I mean, consider the Fed’s MBS purchase program. As of June 3, the Fed had $428 billion in MBS on their books. To simplify, let’s call that $428 billion in incremental demand in period 1. If they Fed just held their position, no new buys or sells, what’s the inflationary impact in period 2? None right? No marginal demand for MBS from the Fed, no money printed. So execution of the exit is relatively easy.
To me its all about timing and will. The timing is a bit of a guessing game. I think we have seen some legitimate green shoots since January of this year. Consumer spending is way down, but no longer seems to be collapsing. Thus there should be some commensurate slowdown in the pace of the Fed’s policy actions. Its also clear that the Treasury buying program has been a major failure, in that it spooked foreign investors. I expect the Fed to let the Treasury program die a quiet death, and let that be their first removal of some accommodation.
But do they have the will? There are those that say the Treasury has made the Fed its padawon. The Fed is creating inflation to help solve the Treasury’s debt problem. I don’t think this is the case, but its a scary thought. It would represent a return to Nixon-era central banking, where the Fed was highly political and thus unwilling to tackle inflation with the steady hand necessary.
Consider this. Will a Fed with an expanded mandate, as the primary regulator of banking and possibly other elements of the financial system, becomes more political? Probably. Will Congress get more oversight of the Fed-as-regulator? Certainly. Will that translate into less independence on the monetary policy side? Its a very big risk.