The Dreaded “I” Word

Yes, the dreaded “I” word. And I am not, not  talking about egotism. Nope, I am referring to that bane of the modern central banker and economist, INFLATION. Yes, inflation, that scourge of civilization where anything less than two percent annual growth in prices will leave these modern financial superheroes quivering in their complex data sets. It is a fate worse than; it’s hard to say; Sarcasm.

Okay, most of you probably don’t remember Monty Python; and most of you probably don’t remember the horrific, OPEC-instigated inflation of the 1970’s. The impact lasted well into the following decade. I remember trading two-year treasury notes with a 12% handle, and ten-year notes not much lower. I only wish those yields were still available.

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But Trish’s article on stagflation brought back the vivid memories of the economic war that was fought to reign in runaway inflation. For those of you who don’t remember, it took Paul Volcker, acting with the full support of President Reagan, pushing the Fed Funds rate to more than 20% to finally break the back of inflation. And yet, with that moment in history little more than a dying flicker of light, we find ourselves with a central bank that is more concerned with the perils of its own inability to engineer 2% inflation, its self-defined statutory mandate.

So, with the collective heartbeats of the members of the Federal Reserve Board racing with anxiety, these guardians of our economic present and future have now set sail for the promised-land of Overshoot; a place where higher prices are allowed to exist for, hmmm… Oh yes, everyone’s benefit. Their idea is to compensate for the undershoot so over time average prices meet their magical target.

Can you all see where this is heading?

Well first, let’s ask ourselves whether stable prices (the Fed’s actual statutory mandate) are bad. Anyone out in Purchaserville unhappy when they buy a new car for the same price as the last one? Oh, you haven’t experienced that.

How about medical care? Nope, not there either.

Tuition for your kid’s education? (The apostrophe before the “s “means you have only one; if you are a member of the audience who has to put the apostrophe after the s, I am so, so sorry.)

Home prices? I can go on and on. I know there are segments of the basket of goods and goodies that have over time experienced downward pressure but, in general, I have no real clue why the Fed thinks that prices are so contained that allowing, or rather FORCING,  prices to increase is a good idea. And, to be honest, why looking backward at a decade of relative price stability, yes, modest growth, and among the lowest unemployment rates in our history is something more to be feared than an angry water moccasin.

So, what is really going on here? I don’t know. Sorry, that’s the answer to a different question. But it is somewhat puzzling. So, again, how can we explain this?

First, according to a friend of mine who was a member of the Fed, 2% inflation can be thought of as oil for the economy. It is the STP-40 of the economy. Interesting thought. But why is 2% oil better than 1.5%; or 1%. Well, the best I can gather is that the lower numbers are too close for comfort to that line in the economic sand; deflation. And, from their perspective deflation, even modest deflation is to be avoided at all costs.

Besides that, the best I can figure is that if we divide the economic pie in two, one which benefits from moderately higher inflation and one which doesn’t, the Fed finds the scales tip towards the inflationistas. It seems like a lot of risk to take for some indeterminate benefit.

The Fed also believes it can easily get a grip on inflation if general price rises become uncomfortable. Given their inability to push prices to target, one can somewhat sympathize with this view. Given their batting average, one can also wonder why they are so confident. And, what if they are wrong? What if inflation gets firm traction? Well, if you remember what it took to regain control, if we have to re-Volckerize, the picture is not pretty. And worse there are some real economic landmines on the horizon that will not turn out well if we find ourselves in the land of the Dreaded I.

Highest Debt-to-GDP-Ratio since World War II

For example, we now find ourselves with the highest debt-to-GDP level since World War II ended; in nominal terms the highest ever. At $25+ Trillion, every percentage point increase in average borrowing costs translates to an extra $250 billion increase in annual debt service costs. Can you imagine the interest costs if the ghost of inflation past has its way? In that environment, even the Yankees couldn’t afford Babe Ruth. And, our debt levels are only going to increase at accelerating rate (for those interested, the Social Security Trust Fund runs out of money sometime around 2034 adding trillions of dollars to annual deficits) which means the impact of rising rates will be more and more destructive

Now embedded in our indebtedness lies one kernel of an explanation; the Fed is currently making money cheaper for the government and private sector to borrow. For the really indebted (not necessarily the thankful sort) that is certainly a positive, at least in the short run. Of course, if they are wrong, there will be hell to pay; I mean a lot of interest. Perhaps we should use the Fed’s own logic to argue that we should worry about the average cost of borrowing over time. Oh, hell, why? Big-time debt loads and interest costs will be someone else’s problem. We haven’t worried about this future stuff before, so why start now?

There are other risks that run through the growth and inflation spectrum. Productivity. Competitiveness. The reserve status of the US Dollar. Structural stability in the economy and markets. And all of these features of our economy will not likely fare well in a high inflation environment. In fact, I think we risk stagflation or, a term I coined some time ago, Deplation. What’s deplation you ask? Depressionary Inflation; stagflation’s big brother.

There is one place where the Fed has been stunningly effective at producing inflation; in asset prices, particularly equities. Now, the Fed does not consider price changes in the largest market in our economy to count as inflation. If you own them, well you probably are happy and probably don’t like my logic. But as I mentioned in a recent article, there is a large swathe of the economy that does not really get stoked by the S&P or NASDAQ; although they certainly find themselves sucking wind when stocks find themselves in free fall. I know, I know, stock prices never fall. And even the slightest whiff of a negative return on equities causes panic sending the Fed to the firetrucks. Not that the Fed accepts responsibility for asset bubbles.

I, on the other hand, do not believe that predictably low or ultra-low interest rates have been such a boon to our existence. They have distorted economic and financial decision-making allowing instabilities to build and propagate through economic and financial systems, at times weakening them to the point of collapse.

For example, Fed-policies were more than contributory to the crisis caused by the collapse of the giant, secretive hedge fund Long-Term Capital, the NASDAQ bubble and the Fed-induced catastrophe of 2008-2009. Yep, you heard that right; the crisis in the mortgage industry, right up to the collapse of Lehman Brothers lands right on the door mat of the Fed. And why? Because they provided so much liquidity, so much predictability, so much low-cost money, that the financial geniuses of the capital markets found a way to engineer one of the worst economic tsunamis in history. In that case, the sense of calm masked an erosion of structural integrity. In the blink of an eye, the arcane world of sub-prime lending and collateralized asset lending turned the world upside down. But this was not the cause, but merely the symptom.

Those policies are the progeny of the more aggressive approaches now in practice. And they are the same tools which the Fed proposes to use in the name of higher inflation. I for one am uncomfortable to say the least. One of these days we are going to wake up and find out that equity prices can go down and not be re-inflated; that real inflation can be everyone’s worst nightmare; and that the Federal Reserve can’t do anything about it without exacting a toll that is too high from any political perspective.

They will, so to speak, be up the river without a paddle.

Neil Grossman

Neil Grossman

Neil Grossman is a mathematician, economist, constitutional law scholar, physicist, and former global hedge fund trader. Neil co-founded the TKNG Global Macro Fund where he was Chief Investment Officer. Prior to establishing the Fund, Neil ran a proprietary trading group that focused on global rates and currencies for JP Morgan Chase where he was also an Executive Director in the Chief Investment Office. Additionally, Neil held senior positions at Norges Bank (the Central Bank of Norway), Five Mile Capital Partners, and Deutsche Bank, where he ran a large derivatives portfolio. Neil has a J.D. from Columbia Law, and an M.S. and B.S. in Fluid Dynamics from Columbia Engineering. Neil also did post-graduate studies in Applied Mathematics and Theoretical Physics at the University of Cambridge. He lives in Millbrook, New York where he presides over his new vineyard.
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