death-knell of Bernankeism
By Martin Hutchinson
producer and consumer price indexes announced last week were significant in that
they sounded the death-knell of Bernankeism. No longer will it be possible to
inflate the money supply by pretending that inflation in the real economy is not
a problem; other means will have to be found to perpetuate the shell-game.
In previous months, the consumer price index (CPI)in particular had
benefited from some very fishy seasonal adjustments to remain close to the Fed's
targets and only a little above 4% on a year-to-year basis. Even so, the rise of
the producer price index (PPI)at 7.2% in the year to May 2008 should have caused
alarms. This month, all possibility of doubt was lost. The CPI rose 1.1%,
putting it fully 5% above its level in June 2007, while the PPI
a staggering 9.2% on a year to year basis.
This puts inflation securely in the 1970s framework. If you look at the
annual figures for 1970s consumer price inflation, you will find only one figure
below 4% (and that in 1972, when price controls were in effect) but you will
find several figures, both in the early 1970s and in the 1975-77 period of
consumer price index quiescence, that were in the 4-6% range. Since a major
effect of inflation is psychological, the fact that inflationary pressure has
decisively moved back into the 1970s range is important.
At 5% per
annum, inflation cannot be ignored. Investors cannot buy fixed-income securities
without taking account of the fact that the principal of those securities will
have devalued by more than half by the time they are repaid (if they are of 15
years or longer maturity.) The combination of inflation and un-indexed income
and capital gains taxes rapidly raises the tax rate on capital returns to an
extremely high level, depressing still further the incentive to save.
the long run, a society with 5% or higher inflation becomes starved of domestic
capital, and long-term investment falls below its optimal level. More important
perhaps, those such as the pensioners and bondholders who entered into long-term
arrangements believing in the soundness of money have effectively been swindled
by borrowers - particularly, in most cases, by the government.
aunt retired in 1948 with her savings primarily in a three-and-a-half percent
British War Loan; by the time she died in the 1970s she was completely indigent,
since the real value of both her capital and income had declined by about 85%,
as had even the money value of her bonds, which were irredeemable. She was a
lifelong Tory voter and had been a great fan of Stanley Baldwin, so doubtless
the postwar Labour government considered her "lower than vermin"; its economic
policies certainly had the effect of treating her as such. My aunt in her
retirement (she previously had a 40-year small-business career) was a rentier
such as John Maynard Keynes wished to euthanize; gee, thanks Maynard!
Since the inflation statistics have changed their nature, monetary
policy will also have to change. Whatever brave words Federal Reserve chairman
Ben Bernanke puts on it, he will not at this stage be able to switch to
"fighting inflation" wholeheartedly. Genuinely fighting inflation would require
real interest rates, even in the short term of at least 3% to 4% - not maybe as
high as the 20% short-term rate - roughly 9% in real terms - that Bernanke's
predecessor Paul Volcker imposed on the US economy, but nevertheless well above
the neutral long term interest rate, which is well above 2%, probably above 2ฝ%.
That would imply a Federal Funds rate in the 9-10% range, well above the
8% that would have been sufficient to fight inflation had Bernanke adopted it in
2006-07. Long-term rates would also have to rise to at least the neutral rate,
or around 8% per annum on 10-year Treasury bonds.
As Bernanke would no
doubt tell you scornfully, a Federal Funds rate of 9-10% and a long term bond
rate of 8% would devastate the US economy, in particular causing further carnage
in the housing market. Very well, if Bernanke's monetary policies (and Alan
Greenspan's before him) have led the US to a position in which fighting
inflation would devastate the economy, then rates must be raised in a two-stage
process. In the first stage, the gradual raising of the Federal Funds rate from
2% to maybe 4% over the next year, inflation will not be fought, and will
consequently continue to rise to perhaps the 7-8% range.
Should he adopt
this policy of modest rises in interest rates, Bernanke will no doubt claim to
be fighting inflation, but he will be doing no such thing, since real interest
rates will remain securely negative. However, even though inflation in general
will continue to rise, it will no longer be in an out-of-control spiral and oil
and commodity prices in particular will probably come off the boil somewhat
(though gold, which has not shared in the sharp commodity price appreciation of
the past year, may still soar towards US$1,500.)
While interest rates
remain in the 2-4% range, house prices will continue declining, but the
inflation and the ongoing modest strength (if growth around zero can be called
strength) of the The US economy will pull wages up towards house prices. The
dollar will remain weak, since US interest rates will remain well below
international rates, but that will have a beneficial effect in rebuilding US
export industries and moving the US current account towards balance. Weakness in
housing and in retail sales will thus be counterbalanced by strength in the
By late 2009, with house prices down around 30-35%
nationwide (and by 55-60% in overbuilt parts of California, Nevada, Florida and
the northeast), the ratio of house prices to incomes will no longer be
unfavorable, and signs will appear of a recovery in the housing market.
At that point, we will reach another decision node. Should Bernanke be
reappointed for a second four-year term in January 2010, in spite of his
manifest failure to control inflation, he will doubtless keep interest rates at
their low prevailing levels, which will cause inflation to begin trending
upwards more sharply, passing 10% annually in early 2010, at which point real
short-term rates will be minus 6%. The result will be crisis, which it is
unlikely Bernanke will prove capable of solving.
The alternative path
will occur if a president John McCain or a president Barrack Obama does not
reappoint Bernanke, preferably asking him to leave office several months early,
and instead appoints a Fed chairman with a proper commitment to fighting
inflation - along the lines of Paul Volcker, although Volcker himself will be 83
in 2010, presumably too old to want to resume his old stressful and relatively
unlucrative job. In this contest, it is gratifying that Volcker is already
advising Obama, suggesting that his relatively mild criticisms of current
monetary policy will be taken to heart.
With housing stabilized, and the
probability of a financial-sector meltdown reduced, the new Fed chairman - let
us call him Volcker II - will be able to take a strong line against resurgent
inflation. The Federal Funds rate will be increased immediately to at least 12%,
which will cause a bond market debacle as long-term Treasury rates readjust
themselves to their new equilibrium level around 10%.
Housing will go
into a renewed funk, but with prices and incomes relatively in balance it should
be a shallow one in terms of house prices, doubtless causing further
bankruptcies among homebuilders but not mass defaults among home mortgages, the
fixed-rate among which will now have interest rates far below the new market
The US economy will enter a sharp recession, somewhat exacerbated
by a recovery of the dollar from the excessively low levels it will have reached
during the easy-money period of 2008-09. However by the end of the slowdown,
with the further decline in retail sales that it will cause, the US savings rate
will have been rebuilt to a modestly positive level and the current account will
be close to balance. As inflation begins to decline and monetary policy to ease,
economic growth will resume, probably in time to help the 2012 re-election
campaign of McCain or Obama.
By 2012, when economic recovery becomes
generally apparent and interest rates begin to ease, the United States will have
suffered five years of economic growth close to zero (and hence negative when
adjusted for population growth) with the construction and financial sectors
declining sharply in importance, and export sectors generally increasing.
Real consumption per capita in 2012 will be well below that in 2007,
although much of that decline will be suffered by the top 1% of income earners
who benefited so fabulously from the cheap-money bubble. Prices will have risen
by about a third over the five years, and there will still be more work to do in
2012-15 before inflationary psychology has been wrung out of the economy - real
interest rates will remain high for some years. However, the recession will have
been nowhere near as deep as the Great Depression, nor will it have been as
prolonged as the Japanese stagnation of 1990-2003.
The real sufferer in
the 2008-12 decline will be stock prices. Judged by its level of 4,000 in
February 1995, the Dow Jones Industrial Index should today be standing at a
level of 7,800 (when you increase it in line with nominal gross domestic
product) compared with its actual level of 11,400. That would suggest a moderate
decline of a further 30% from the Dow's current level, a total decline of about
45% from its 2007 high. However, that fails to take account of the marketís
position in February 1995; at that point it was at an all-time high, almost 50%
above what had seemed the unsustainable peak of 1987.
If we measure the
Dow instead by the increase in nominal GDP from its value at the beginning of
the great bull market, of 777 in August 1982, it should bottom out around 3,400
today or about 4,500 in 2012 allowing for inflation between now and then. That
is probably a more reasonable estimate for the low; conditions in 2012 will be
those of tight money following a lengthy recession, very similar to those of
1982 but not to those of 1995, which were much sunnier.
Hence a decline
not of 45% but of 70% in the Dow index is on the cards, with correspondingly
severe devastation in baby-boomers' retirement portfolios (only part of which
will be in stocks, but the rest will mostly be in debt, affected like my
great-auntís savings by both rising interest rates and inflation.)
THAT doesn't get people saving like squirrels, nothing will!
Martin Hutchinson is the author of Great Conservatives
(Academica Press, 2005) - details can be found at
(Republished with permission from
2005-07 David W Tice & Associates.)