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Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com
The 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 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 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
rose 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. In 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.
My great-aunt retired in 1948 with her savings primarily
in 3½% 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 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 Fed 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 3-4% -- not maybe as high as
the 20% short term rate – roughly 9% in real terms – that Paul Volcker imposed
on the US economy, but nevertheless well above the neutral long term interest
rate, which is well above 2%, probably above 2½%. 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 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 $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
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
export sector. By late 2009, with house prices down around 30-35% nationwide
(and by 55-60% in overbuilt parts of California, Nevada, Florida and the
North-East) 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 President McCain or
President Obama do not reappoint Bernanke, preferably asking him to leave
office several months early, and instead appoint 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 un-lucrative 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 level.
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 President McCain or President 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 to its actual level of
11,400. That would suggest a moderate decline of a further 30% from the Index’s
current level, a total decline of about 45% from its 2007 high. However, that
fails to take account of the market’s 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 Index 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-aunt’s savings by both rising
interest rates and inflation.)
If THAT doesn’t get the bastards saving like squirrels,
nothing will!
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