Due to space constraints, unfortunately, I have to assume from my readers some familiarity with the material I am talking about (or I just won't be able to say all I want to say). Luckily, a couple of hours after I submitted my column, Rebecca Wilder posted an excellent entry on all the buzzwords I was using in my column. If you have read my column, I definitely recommend you to read hers as well, even if you are familiar with quantitative easing, money multiplier and the like. You'll note that even though we are using a similar line of thought, she is a bit more optimistic than me on a potential inflation threat. Credit Writedowns summarizes her points as well as explain quantitative easing a bit more using Japan's example.
At my inaugural column last week, I explained that the deflation hype was rather exaggerated, as the two commonly-quoted signs of deflation, U.S. October inflation and yields on American inflation-protected securities, were not accurate indicators at all. However, other market prices such as weakening oil and dividend yields on stocks surpassing yields on 10-year Treasuries have been pointing to deflation as well.
It seems that the market is definitely pricing for Deflationary Inferno even if deflation itself is not very likely. However, the alternative, Inflationary Purgatorio, is still far off the the markets’ radar. While many have learned to trust markets painfully, my overconfidence stems from the ongoing and prospective firefighting. After all, as a reader rightly noted, “numbers are important, but it is government policy that will shape the future”. And both fiscal and monetary policy are pointing towards eventual inflation.
The direction of monetary and fiscal policy
Even though he has been quick to announce his Economics team, you should not expect anything on the fiscal front until Obama settles in. This means that we are not likely to see the effects of fiscal policy on the economy until the second half of 2009 at the earliest. But once the stimulus comes, it is likely to be on the larger side because as this year’s Nobel Prize winner Paul Krugman notes, unlike monetary policy, fiscal policy is inherently asymmetric: It is easier to fix too much of it with contractionary monetary policy than too little of it with another stimulus package. Therefore, when it comes, the fiscal boost is likely to have an inflationary bias.
While fiscal policy is still far away, the Fed has had its hands full for some time now. While traditional monetary easing has not been effective, it has been complemented with more unorthodox tools such as intervening directly in credit markets. As the so-called quantitative easing is now semi-official, we can expect more of such creative policy from the Fed, whose balance sheet is starting to look increasingly like a hedge fund’s. In a similar vein, last week’s announcement that it would purchase USD 100bn in debt obligations from GSEs –government sponsored enterprises- is a first step in the monetization of public debt. With the low money multipliers, Fed’s actions are having a very limited impact on money supply for now. But the mere fact that the Fed is willing to shift to the extreme of policy means that it is not worried about inflation at this point.
Market implications, risks, and short-run outlook
Crises are always marked by the breakdown of time-tested relationships, but two interesting anomalies have emerged lately: Stocks have rallied while yields on the long end of the curve have fallen and the well-known positive correlation between dollar and long-dated Treasuries has broken. The scenarios I have explained above might shed some light on what is going on.
The recent flattening of the yield curve hints that quantitative easing is well-understood by markets, but its implications are not: All that liquidity and fiscal stimulus could find its way to inflation, which would in turn raise interest rates. With a huge US and global bond supply, we could even end up with a considerable bond market crash and another recession before the recovery from the current one is completed. While this dreaded W-shaped outlook is unlikely to pose a threat before the second half of 2009, it is in line with the anomalies above and paints a rather confusing outlook for the dollar (to be continued).
At my inaugural column last week, I explained that the deflation hype was rather exaggerated, as the two commonly-quoted signs of deflation, U.S. October inflation and yields on American inflation-protected securities, were not accurate indicators at all. However, other market prices such as weakening oil and dividend yields on stocks surpassing yields on 10-year Treasuries have been pointing to deflation as well.
It seems that the market is definitely pricing for Deflationary Inferno even if deflation itself is not very likely. However, the alternative, Inflationary Purgatorio, is still far off the the markets’ radar. While many have learned to trust markets painfully, my overconfidence stems from the ongoing and prospective firefighting. After all, as a reader rightly noted, “numbers are important, but it is government policy that will shape the future”. And both fiscal and monetary policy are pointing towards eventual inflation.
The direction of monetary and fiscal policy
Even though he has been quick to announce his Economics team, you should not expect anything on the fiscal front until Obama settles in. This means that we are not likely to see the effects of fiscal policy on the economy until the second half of 2009 at the earliest. But once the stimulus comes, it is likely to be on the larger side because as this year’s Nobel Prize winner Paul Krugman notes, unlike monetary policy, fiscal policy is inherently asymmetric: It is easier to fix too much of it with contractionary monetary policy than too little of it with another stimulus package. Therefore, when it comes, the fiscal boost is likely to have an inflationary bias.
While fiscal policy is still far away, the Fed has had its hands full for some time now. While traditional monetary easing has not been effective, it has been complemented with more unorthodox tools such as intervening directly in credit markets. As the so-called quantitative easing is now semi-official, we can expect more of such creative policy from the Fed, whose balance sheet is starting to look increasingly like a hedge fund’s. In a similar vein, last week’s announcement that it would purchase USD 100bn in debt obligations from GSEs –government sponsored enterprises- is a first step in the monetization of public debt. With the low money multipliers, Fed’s actions are having a very limited impact on money supply for now. But the mere fact that the Fed is willing to shift to the extreme of policy means that it is not worried about inflation at this point.
Market implications, risks, and short-run outlook
Crises are always marked by the breakdown of time-tested relationships, but two interesting anomalies have emerged lately: Stocks have rallied while yields on the long end of the curve have fallen and the well-known positive correlation between dollar and long-dated Treasuries has broken. The scenarios I have explained above might shed some light on what is going on.
The recent flattening of the yield curve hints that quantitative easing is well-understood by markets, but its implications are not: All that liquidity and fiscal stimulus could find its way to inflation, which would in turn raise interest rates. With a huge US and global bond supply, we could even end up with a considerable bond market crash and another recession before the recovery from the current one is completed. While this dreaded W-shaped outlook is unlikely to pose a threat before the second half of 2009, it is in line with the anomalies above and paints a rather confusing outlook for the dollar (to be continued).
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