inflation or deflation

[Sheraz Hussain]

Hi William

 

I have come across a few articles namely on Bloomberg about Quantitative Easing and the whole inflation/deflation story that the US faces. One of the comments I have read is that QE is inflationary as the actions of the FED are akin to ‘printing money’ and will create inflation.

I am trying to understand from reading previous posts if this statement is true.

My understanding/logic is that when the FED participates in QE they buy for example a fixed amount of Treasury securities which is ‘monetization’ of debt. This creates a cash deposit for the seller in a bank account and a reduction in the outstanding treasury debt. As a result all that has happened is the quantity of reserves in a bank have increased. Which would imply the result of QE is to increase the amount of reserves in the banking system (I am ignoring the benefit of a lower yield curve from the QE action). By having a lot more reserves in the system this would not imply higher inflation. I guess this may be true in a normal functioning lending environment as it would be equivalent to downward pressure on Fed Funds rate. If however the system has been flooded with reserves for so long why would the FED repeat and do something which will have little or no effect?

I also read a comment saying deflation is always reversible in a fiat economy as there is potentially unlimited supply of $ so the currency is debased? Is this true

I hope what I have said is clear and I welcome your feedback on this.

 

Thanks sheraz

 

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[William Hummel]

On 10/18/2010 9:19 AM, Sheraz Hussain wrote:

Hi William

 

I have come across a few articles namely on Bloomberg about Quantitative Easing and the whole inflation/deflation story that the US faces. One of the comments I have read is that QE is inflationary as the actions of the FED are akin to ‘printing money’ and will create inflation.

I am trying to understand from reading previous posts if this statement is true.

My understanding/logic is that when the FED participates in QE they buy for example a fixed amount of Treasury securities which is ‘monetization’ of debt. This creates a cash deposit for the seller in a bank account and a reduction in the outstanding treasury debt. As a result all that has happened is the quantity of reserves in a bank have increased. Which would imply the result of QE is to increase the amount of reserves in the banking system (I am ignoring the benefit of a lower yield curve from the QE action). By having a lot more reserves in the system this would not imply higher inflation. I guess this may be true in a normal functioning lending environment as it would be equivalent to downward pressure on Fed Funds rate. If however the system has been flooded with reserves for so long why would the FED repeat and do something which will have little or no effect?

I also read a comment saying deflation is always reversible in a fiat economy as there is potentially unlimited supply of $ so the currency is debased? Is this true

I hope what I have said is clear and I welcome your feedback on this.

Sheraz,

I think you have it exactly right.  QE could result in inflationary pressures in the long run if the Fed does not recapture the money and excess bank reserves it created when the economy begins to show solid growth again.  However there is no such pressure now and probably won't be for at least another two years. The banking system is still loaded with questionable assets.  The housing market is in terrible shape and may get worse because of the mortgage documentation mess.  Consumer confidence is very weak because of the large unemployed population and concern over job security for those who are employed. 

I think further QE, which now appears likely, is foolish.  Long term interest rates are already at historic lows.   More QE will do very little to stimulate bank lending and will only make recapture of excess reserves more difficult. The increased money supply will simply swell bank deposits and money market funds until the economy shows convincing signs of recovery.

William

[Terry Hammonds]

One thing about our flat to deflationary economy is that people on Social Security will not get a Cost Of Living Adjustment.again this year.  Very few in congress actually know anything about rules for S.S and Medicare.  They keep thretening to raise the age of retirement so they don't know that is already happening.  You are no ,longer able to be "fully retired" at age 65.  It went up to 65 and 8 months and is scheduled to continue rising to age 68.  .  ..  .    --- On Mon, 10/18/10, William Hummel <wfhu...@ca.rr.com> wrote:

[Mark Bachmann]

The question well-stated and expresses the befuddlement that a lot of people are feeling over the rationale for another round of QE at this time. For the same reason it's unlikely to be inflationary in the short-term, it seems unlikely to do much good either, so why bother? The answer, I think, is that it is politically unacceptable for the Fed to acknowledge that it's options are exhausted. So they're increasing the redundancy of excess reserves in the system in an effort to bring down longer term rates from levels that are already pretty low from the perspective of people who depend on income from savings.

 

In my opinion, the strategy is not as low risk as the fed guys seem to be assuming, since they may find it difficult to withdraw the excess reserves again if inflation ticks up, due to fears of re-triggering recession. I don't think they have a lot of safe middle ground on which to be experimenting.

 

   Mark Bachmann

[Mark Bachmann]

Good thing this isn't France.

 

     Mark Bachmann

[Dick Knox (Los Angeles - California)]

THE PROCESS AS I UNDERSTAND IT (maybe all of this is obvious?)

There is a connection between the rate of change of asset prices and
the rate of change of GDP.

When asset prices are rising (INFLATION) it is easy to get credit
backed by assets. Thus money is available to investors and consumers
and they spent it. GDP grows. Animal spirits are positive.

When asset prices are falling (DEFLATION) it is hard to get credit
backed by assets. Asset based debt needs to be paid down. Thus money
is not available to investors and consumers, they reduce their
spending, debt is paid down. GDP shrinks. Animal spirits are
negative.

There is positive feedback due to the animal spirits effect. Credit
standards are lowered during growth, tightened during shrinkage.

During growth GDP heads to plus infinity - but the feedback mechanism
is non linear - in fact bi polar. At some point it switches, everyone
panics, asset values drop and we flip quickly into shrinkage mode.

Shrinkage mode brings in many moderating factors - government transfer
payments, debt repudiation due to bankruptcy, etc. Whereas enthusiasm
arrives quickly riding on the back of greed, fear and panic depart
slowly accompanied by humility and embarrassment. So its dynamic has a
lot of damping. Growth is like running on the land. Shrinkage is like
running under water.

THE FED ABHORS DEFLATION

Once you get deflation it is self reinforcing. Hard to get back. USA
in the 30‘s, Japan in the 90‘s.

So the FED is dedicated to causing inflation. They like 1.5% but they
insist on some positive value.

This involves not only adding money, but buying - thus putting upward
pressure on prices. Both the Chairman and the Pres of the NY Fed have
said they plan to do both. The NY Pres has been more direct in his
statement. Both spoke in reserve-ese - so it takes just a tiny bit of
translation to understand their messages.

DO I HAVE IT RIGHT?

and a closing piece - when the animal spirits start to come back then
there is the potential of an inflation explosion - and further - to
the extent that these strategies can be anticipated some will do the
opposite of what is expected with the hope that they can second guess
when the turn will come.

And a side advantage of the Fed's approach is the the currency loses
value and thus shifts the trade balance.

[John Hermann]

At 10:32 AM 19/10/2010, Dick Knox wrote:
>During growth GDP heads to plus infinity - but the feedback
>mechanism is non linear - in fact bi polar. At some point it
>switches, everyone panics, asset values drop and we flip quickly
>into shrinkage mode.

The correct word for describing the nonlinear flipping process is
bistability. This is bistable switching. When the debt load grows
to a certain value (the switching point), any small fluctuation then
suffices to flip the system from an expansionary mode to a
contractionary mode. -- John Hermann

[Dick Knox (Los Angeles - California)]

John

> The correct word for describing the nonlinear flipping process is
> bistability. This is bistable switching.

Thanks

Dick

being playful - maybe it is also bi-polar (switching from manic to
depressive?) ala Baby Face Nelson in Brother where art thou (I'm a big
cohen bros fan)

[Sheraz Hussain]

Thanks for the commentary, another question I was thinking about was with Japan and how they have been struggling for many years with deflation and low growth..Surley they have the required tools and have used QE on several occasions but there is no real success and rates are extremely low and have been for a long time. I find it interesting and somewhat concerning if the US was to follow a similar path as of Japan but could this really happen?

 

From: understan...@googlegroups.com [mailto:understan...@googlegroups.com] On Behalf Of William Hummel
Sent: 18 October 2010 18:05
To: understan...@googlegroups.com
Subject: Re: inflation or deflation

 

On 10/18/2010 9:19 AM, Sheraz Hussain wrote:

[Dick Knox (Los Angeles - California)]

On Oct 19, 9:43 am, Sheraz Hussain <shuss...@bluebayinvest.com> wrote:
> Thanks for the commentary, another question I was thinking about was with Japan and how they have been struggling for many years with deflation and low growth..Surley they have the required tools and have used QE on several occasions but there is no real success and rates are extremely low and have been for a long time. I find it interesting and somewhat concerning if the US was to follow a similar path as of Japan but could this really happen?
>

Many believe it is happening - see e.g. Krugmans columns in the NY
Times

There are 2 issues (the following is my opinion and should not be
mistaken as a statement of fact)

1 -Not everyone agrees on the correct solution

2 - There are politicians who are more interested in the power
struggle between the parties than they are in trying to understand.

If my congressman is an example - he personally does not have the
capacity to understand. He is a likable fellow - backed by a strong
group of local businessmen. He dropped out of college where he was
studying animal husbandry. His church later orgnized to give him a
degree from a university they own. His parents owned a local business.
But his church organizes big crowds that give the impression that he
is backed by the community.

If you contemplate the Paulsen/Congress episode when the collapse
happened, few of the legislators were suffieiently eggheaded to
understand what was going on.

But they have learned how to pose for the camera.

And that - plus the cash to buy TV time - is how you get to decide the
future of the US and A.

[William Hummel]

On 10/19/2010 9:43 AM, Sheraz Hussain wrote:

Thanks for the commentary, another question I was thinking about was with Japan and how they have been struggling for many years with deflation and low growth..Surley they have the required tools and have used QE on several occasions but there is no real success and rates are extremely low and have been for a long time. I find it interesting and somewhat concerning if the US was to follow a similar path as of Japan but could this really happen?

Many economists are concerned about the prospect of the US being caught in a deflationary trap similar to that of Japan. Of course no one really knows what the future holds. I think a protracted deflationary period is quite possible if the government sets a balanced budget as its top priority. That would lead to increased job losses and further reduction in aggregate demand. In any case it will take a long time to climb out of the hole we are now in, even with more government stimulus spending.

There are some factors that work in our favor. The US dollar remains the world's reserve currency with no other likely to dislodge it for many years to come. The US has the most innovative and entrepreneurial economy in the world, and there is little sign that has changed, although others are catching up. Some of the worst behavior of the US financial sector is being curtailed under the new rules, although not nearly as effectively as it should be.

The Japanese real estate bubble was much more severe than the American one. In 1989, property in Tokyo's Ginza district reached a price of nearly US$100,000 per square foot. Prime property in Tokyo's financial district dropped to 1% of its peak value by 2004. Collateral on loans simply cratered in Japan, and that large a financial hole doesn't disappear in just a few years.

William

[Jean Erick]

     My viewing of the last "Bubble" panel of Oct 6 confirms the assessment in your first paragraph.

Now, I'm confused(no remarks please).  I was thinking quantitative was buying the MBS's.  But, in any case,  from "Bubble" again. The FED is quacking about setting long term inflation targets so won't this simply entail monetizing debt.  Again, quantitative or qualitative?

 

James

----- Original Message -----

From: William Hummel

To: understan...@googlegroups.com

Sent: Monday, October 18, 2010 10:04 AM

Subject: Re: inflation or deflation

[Jean Erick]

    If the inflation targeting works, it almost makes me laissez faire.  We just need to put a gun to their heads so they keep doing the right thing.

 

James

----- Original Message -----

From: Mark Bachmann

To: understan...@googlegroups.com

Sent: Monday, October 18, 2010 11:49 AM

Subject: Re: inflation or deflation

[Jean Erick]

     I think that's "Cohn" bros.  Missed that movie.

     I'm thinking you're missing something about this debt switching business.    I think you were talking about it in terms of it being a causal element.

I think it's a "resultal"  ;-) element.  It occurs a little after the arc of boom over supply slow down, and the "switch is more accurately despcirbed as a plumet.

 Unless you've got a bunch of scardy cat FED's who go ape and pad the bottom with money.  But maybee your talking about reccessions?

 

James

----- Original Message -----

From: Dick Knox (Los Angeles - California)

To: Understanding Money

Sent: Monday, October 18, 2010 11:49 PM

Subject: Re: inflation or deflation

[Jean Erick]

     The US chooses to accept more destructive capitalism than Japan and we are more agile in political, cultural change.

 

James

[jim blair]

Hi,

 

Are you saying that the US is more dynamic and flexible, while Japan is more static and rigid?   If so I agree, and won't be moving to Japan any time soon ;-)

[Jean Erick]

     Well, perhaps you would feel more at home in a culture that is similar to the way you are probably becomming more and more.  ;-)

[Darren Bedwell]

Mark Bachmann wrote:
> The answer, I think, is that
> it is politically unacceptable for the Fed to acknowledge that it's options
> are exhausted.

One option that the Fed still has that I am a bit confused has not
received more attention is reducing the interest rate that they are
paying on excess reserves. There is almost $1 trillion in aggregate
excess reserves at depository institutions right now earning 0.25%
(interestingly enough, the arbitrage opportunity still exists in the
federal funds market as the federal funds rate is still at 0.19%, but
that's a different issue I suppose). Reducing the interest rate from
0.25% to 0% or less would directly motivate banks to do what QE is
indirectly trying to influence them to do, namely to lend out their
reserves and start moving it through the economy.

[Joe Leote]

FED either knows, or should know as the bank regulator, the state of the
balance sheets of the major banks.

If the banks issue more loans, they increase leverage, but the banks are
already over-leveraged and threatened with insolvency if asset prices fall
further. Law suits are now urging, for example, Bank of America to take more
billions of bad loans back from pension funds, which would add leverage. BOA
took over Countrywide, and lots of bad paper went through that paper mill.

So why should FED encourage banks to increase leverage when bad asset
disputes are threatening to force huge increased leverage back onto the
banks?

So FED is not encouraging more bank loans. It bought over $1 Trillion in
Fannie/Freddie paper in 2009.

According to one paper I posted a while back (lost the reference), deposits
at FED of Fannie/Freddie, China, and other foreign interests are permitted
to be lent below the Fed funds target rate. So the FED funds transactions
below 0.25 mean Fannie/Freddie and/or Foreign FED depositors are probably
the primary lenders in this market recently, consistent with the $1 Trillion
plus FED paid Fannie/Freddie during QE.

Since these QE purchases piled up in the banks creating excess reserves, to
keep this money out of the markets, FED pays interest above the operating
FED funds rate.
This strategy would accomplish the primary objective of helping banks
de-leverage (income from excess reserves can be booked to retained earnings
as capital and used to buy Treasuries, which helps deleverage the system)
and very slowly identify and clear the bad loans from bank balance sheets,
which threaten further insolvency if the price of toxic assets keeps
plunging, or if banks are required to take back toxic paper via litigation
pressure.

Joe

----- Original Message -----
From: "Darren Bedwell" <darren.e...@gmail.com>
To: "Understanding Money" <understan...@googlegroups.com>
Sent: Tuesday, October 26, 2010 2:09 AM
Subject: Re: inflation or deflation

[William Hummel]

The Fed got authority from Congress to pay interest on Fed funds (bank reserves) starting in October 2008.  At that time the Fed funds target rate (on overnight interbank loans) was 1.0%, down from 2.0% just two months earlier.  The Fed had not yet begun its quantitative easing program so there were essentially no excess reserves in the banking system at the time. The interest rate paid on Fed funds was set below the target Fed funds rate and thus no incentive for banks to hold excess reserves just to earn interest.

Economic conditions deteriorated rapidly and the Fed began quantitative easing a few months later. The actual Fed funds rate (interbank lending rate) went to nearly zero due to the large excess of reserves injected into the banking system by QE. The Fed then modified its policy and set the interest paid on Fed funds above the Fed funds target rate, in effect a free lunch for banks. Whether that was intended to help the big banks improve net worth or was simply a by-product of QE policy I don't know. In any case it removed most of the incentive for banks to use the excess reserves to back increased lending in the open market.

Presumably the big banks are now getting well from various other sources of income. If so, then the policy of paying banks on Fed funds they hold no longer makes sense. However the Fed cannot simply end the payment of interest on reserves without some embarrassment because it had long been seeking that authority.

At some point, the Fed must increase the Fed funds target rate to avoid inflationary pressure due to overly cheap credit from banks. Ideally it should do that after it has recaptured the excess reserves it created through QE. However that will take time because the Fed can't rapidly sell off its huge portfolio of MBS without suffering significant losses. In the meantime, the only way it can increase the interest rate on bank loans is to increase the rate it pays on Fed funds held by banks. In effect the Fed would competing with private sector loans as a source of income for banks. That is, it would absorb some of the lending that banks would otherwise make with their excess reserves and raise the interest rates that banks charge on loans.

When the economy begins to recover and bank interest rates return to normal, the only way the Fed can end the free lunch for banks is to eliminate the excess reserves in the system. It can pay interest on Fed funds, but only at a rate below the target Fed funds rate.  That spread should be at least 0.5%, and perhaps as much as 1.0% which the Fed originally intended when it won authority to pay interest. With a sufficiently high spread, banks would have little incentive to sit on any excess reserves they might hold just to earn interest.

William

[Joe Leote]

William,

 

Can't Fed absorb a loss on its MBS if that is what best serves the markets and stability of the financial system?

 

Is not the real challenge of unwinding its position mostly one of not disturbing the markets with surplus MBS which would depress prices of comparable assets already trading and on the books of financial institutions? The comparable MBS are held by banks, pension funds, 401(k) investors, and all sorts of folks who panic during asset price deflation, so Fed must walk a tightrope to permit some asset price deflation or asset price moderation with triggering commodity price inflation. Whether it makes a gain or loss should not matter to the Source of liquidity since it will always be able to pay salaries and operating costs absent a riot in the streets and rejection of its Federal Reserve Notes as money.

 

Joe

 

 

----- Original Message -----

From: William Hummel

To: understan...@googlegroups.com

Sent: Tuesday, October 26, 2010 1:42 PM

Subject: Re: inflation or deflation

[William Hummel]

On 10/26/2010 11:52 AM, Joe Leote wrote:

William,

 

Can't Fed absorb a loss on its MBS if that is what best serves the markets and stability of the financial system?

The Fed itself would not take the hit from losses on its MBS sales.  The Fed would merely end up rebating less to the Treasury due to its reduced earnings, so the losses would end up as increased Federal debt. 

Is not the real challenge of unwinding its position mostly one of not disturbing the markets with surplus MBS which would depress prices of comparable assets already trading and on the books of financial institutions? The comparable MBS are held by banks, pension funds, 401(k) investors, and all sorts of folks who panic during asset price deflation, so Fed must walk a tightrope to permit some asset price deflation or asset price moderation with triggering commodity price inflation. Whether it makes a gain or loss should not matter to the Source of liquidity since it will always be able to pay salaries and operating costs absent a riot in the streets and rejection of its Federal Reserve Notes as money.

Your point is well-taken. The Fed must avoid influencing asset prices in the credit markets as much as possible because that could impact the economic recovery itself.

William

[Joe Leote]

William,

 

The Fed is attempting to influence asset prices by not permitting massive asset price deflation and panic to ensue. Many of its special liquidity programs in the crisis served only this function of preventing rapid asset price deflation. What triggers massive and rapid asset price deflation is lots of short term borrowing against all sorts of assets feeds the bubble on the way up. Then interest rates rise in a key short-term market, both Repo and LIBOR had a steep basis point increase at some time during the crisis, and then the markets cannot turn a profit running short term money through the creation of new financial paper by pledging old paper as collateral, both the collateral requirements and the fees on new paper get squeezed. This is a modern bank run since the asset prices were pumped up by all the trading of stocks and bonds for working capital in overnight wholesale markets.

 

Those who blame merely the subprime housing market get the story wrong, since it was the model of creating all sorts of junk paper, using overnight funds as operating capital, to sell into MBS and ABS portfolios of long term investors at a profit, that really corrupted the system. Had Fed not stepped in to provide liquidity in each and every market where the parties lost trust in each other (but not Fed) then asset prices would plunge, creditors would have to sell stocks or bonds to make margin calls, assets would plunge further, and the result would be an unholy mess.

 

This is why I say Fed is trying to engineer a soft deflation or a careful re-inflation of the assets. I agree with you that economic recovery of the real economy is in the long run the only good medicine, but given our legal structure, market structure prone to panics, and leveraged banking structure Fed is not in a position to help the economy without helping to float asset prices via soft-deflation or a moderate re-inflation. This means affecting asset prices with a strategy that permits some kind of bankruptcy or bad asset clearing process alongside its liquidity programs.

 

Joe

----- Original Message -----

From: William Hummel

To: understan...@googlegroups.com

Sent: Tuesday, October 26, 2010 3:36 PM

Subject: Re: inflation or deflation

[Jean Erick]

     I think you might be mis-identifying the basic here.

The basic is that we had a false economy.  There was no and therefore there is no economy now.

So they are sitting on losses that they don't want to look at because an accounting would show them to be invsolvent.

Yes, falling asset prices would, of course, make it worse.  And latest word is that housing is headed down for another %5-10%.

So they're just sitting there, having nothing to make money with, letting the lax regullated "bucket" of defaults boil.

Hoping nobody will make them fess up until things pick up and they can become solvent again.

     This would be all fine except for the unemployed.  That is a festering problem that is more like to cause problems

the longer it goes on.  9 meals away from revolution.

     Also, why would they want to lend money is a falling dollar atmosphere?  They'll get back a dollar worth less then they lent.

     The way out, if the FED moves the way it has muttered, is to an acceptable level of inflation.  That will employ people and

lenders will see a better economy coming & can set interest for a profit if they know what the FED intends.

     I would give you a better analysis but then I would have to charge you a fee for my consultation.

 

James

[Terry Hammonds]

There is a lot of money in Credit Default Swaps.  Why help make things solvent when you have bets on default? This is a crazy way to run an economy.  It is a "tug of war" game and those betting on default seem to be winning.  If we eliminated profits from default, there would be more effort toward recovery for all. --- On Tue, 10/26/10, Joe Leote <tech_a...@verizon.net> wrote:

[Terry Hammonds]

It seems to me that we are trying to put small bandages on a seriously wounded financial/economic system.  We need structural change to a system that is in serious trouble.  I am not sure anyone knows how to make those changes or if they do, they are unwilling to make them.  America is in a fundamental world-wide economic shift.  "The rise of the rest" as Fareed Zakaria puts it in his book "The Post-American World." Our present system is no longer geared to lead in the rapidly changing global economy.  The last time we did lead it was along a path to financial ruin.

--- On Tue, 10/26/10, William Hummel <wfhu...@ca.rr.com> wrote:

From: William Hummel <wfhu...@ca.rr.com> Subject: Re: inflation or deflation To: understan...@googlegroups.com