Streetwise Professor

April 6, 2009


Filed under: Economics,Financial crisis,Politics — The Professor @ 8:53 pm

I’ve mentioned several times that I have invested in Treasury Inflation Protected Securities, or TIPS, due to my serious concern that inflation is a major threat given the Fed’s vast expansion of base money.*  That idea is apparently going mainstream, with many big “real money” managers taking the same position:

At  BlackRock Inc., Vanguard Group Inc.,  Pacific Investment Management Co.and Pictet & Cie Banquiers, concerns are growing that policy makers will struggle to control inflation once economies start to recover. The Federal Reserve, Bank of England and European Central Bank have increased money supply by an average 9.2 percent in the past year, or the equivalent of $2 trillion, to $24 trillion, according to the broadest measure each uses.

. . . .

“Inflation worldwide is going to surge in the years to come,” said  Mickael Benhaim, who manages about $32 billion as head of global bonds at  Pictet  in Geneva. “On the supply side, issuance of the securities as a ratio of overall government debt is sharply declining,” which “makes linkers look very attractive,” he said.

Benhaim says there’s a shortage of inflation-linked debt in the U.K. too. There are about 180 billion pounds ($266 billion) of index-linked gilts outstanding, or 23 percent of the total debt, down from 30 percent a year ago, U.K. Debt Management Office data show.

In the euro region, where the ECB targets an inflation rate of just under 2 percent, the market totals about 250 billion euros ($336 billion), or 7 percent of all outstanding debt, down from 7.2 percent a year ago.

TIPS Cheapest

BlackRock‘s Weinstein said TIPS are the cheapest inflation- linked bonds. Notes maturing in one, two and three years have the smallest breakeven rates outside Japan, where deflation expectations persist through 2010’s first quarter, according to the median response in a Bloomberg survey of 16 economists.

“On a  relative value  basis, the U.S. inflation market is the one I would rather  own,” Weinstein said. “If I could sell U.K. breakevens and European breakevens and buy U.S. breakevens, I would.”

Of course, not everybody has a clue:

“Inflation is driven historically by wages, and clearly if you have the unemployment rate rising, it begs the question where will you get inflation from,” said  Chris Lupoli, executive director for global inflation-linked strategy at UBS AG in London. “We’re projecting that there will be a global healing but that the recovery will be anemic.”

Uhm, Chris, the Phillips Curve died like, you know, 30 years ago.  Heard of stagflation?  It is possible to have both high unemployment and high inflation.  

I have repeatedly heard it said that the Fed has the tools to combat inflation when money demand/velocity picks back up again.  It can sell the securities it has bought to sop up the additional money it injected into the economy when it purchased them.

I have no doubt the Fed has the tools.  The question is: Does it have the will to use them?

I have very, very, serious doubts that its promises to fight inflation are credible.  Would the Fed really sharply increase interest rates when the economy is just recovering from a deep recession/depression, running the risk of aborting a resurgence of growth?  Is it likely that the Fed will sell large quantities of mortgage backed securities, potentially driving up mortgage rates and reducing housing prices, thereby risking another housing crash?  Will the Fed be able to resist the political pressure to monetize Obama’s huge deficits?  Moreover, the Fed’s involvement in the various bailout plans, its close cooperation with Treasury, and the rampant populism on the Hill, all raise the risk that the Fed’s independence has been compromised.  Given these factors, the risk of an unprecedented inflationary spurt is appreciable.

Or, to put it differently, in my view the only way we are likely to avoid a serious uptick in inflation is if the economy remains mired in near depression conditions.  I estimate that the odds of a non-inflationary recovery are very low.

I am not alone.  James Hamilton said it better than I could:

A second concern I have with the new Fed balance sheet is that it has seriously compromised the independence of the central bank. To my knowledge, every hyperinflation in history has had two key ingredients: (1) budget deficits that could not be resolved politically, and (2) a central bank that assumed the obligations that the fiscal authority could not.

In the U.S. today, there is little question in my mind that repaying the projected deficits with tax increases or spending cuts will be extremely difficult politically. Each additional trillion dollars would roughly require  doubling the personal income tax rate  on all Americans for one year, something I cannot see the political process delivering. There is enormous pressure in the current situation to defer solutions and look for temporary fixes with off-balance-sheet measures. The reason that the Fed is sought as a partner for the Treasury in all these new actions is because the Fed is perceived to have deeper pockets than the Treasury. This is not a situation that a self-respecting central bank should let itself get into.

My third concern is that the new Fed balance sheet has handicapped the Fed’s ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation. Which of the Fed’s new assets would it sell off when it needs to  absorb back in  the huge volume of reserves it has recently created? The Fed’s hoped-for scenario is that the reserves won’t need to be called back in until the situation has stabilized and the facilities are no longer needed. But I am concerned instead about the possibility of a dramatic shift in the perceptions of foreign lenders, in which case inflationary pressures could emerge in a situation that is far more chaotic than the one we currently face.

I recommend instead that the Fed should be buying Treasury Inflation-Protected Securities in the current situation.  Tim Iacono  says that’s like the Mafia buying “protection” from itself. But my point is that TIPS represent an asset that would gain in value at a time the Fed needs to sell them, meaning that the logistical ability of the Fed to drain reserves quickly in such circumstances is without question.

What we need in the current situation is a central bank that is a bulwark of stability. A profound lack of confidence in the U.S. government itself would make our current problems look like a walk in the park. If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.

But it’s not clear the Fed has either the means or the credibility.

Not clear at all.

The potential for an inflationary outbreak is not bad news for everybody, though.  It is good for those long commodities, especially oil.  Indeed, the best hope for Russia, Iran, Venezuela, etc., is substantial dollar inflation.  An incredible Fed could be Putin’s best friend.  

* I do not offer investment advice.  Period.  I only mention this to indicate that I am putting my money where my mouth is.  

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  1. 1. When you talk of inflationary risks (about which I agree), what precisely do you have in mind? 5%? 15%? 500%? Etc.

    2. Surely if there is big inflation and debt crisis, investors will drop $-denominated assets and oil prices will stop being denominated in $’s, thus canceling out the benefits for petro-exporters (furthermore, if the US loses the ability to pay for oil imports then its price will drop dramatically and for a prolonged period, and actually hurt the petro-exporters quite a lot).

    Comment by Sublime Oblivion — April 6, 2009 @ 9:36 pm

  2. 1. North of 10 percent. 500 percent–not likely. Something like late-70s, early-80s–10-15 pct is my forecast. FWIW. Wide confidence interval around that, though, due primarily to uncertainty about political will of the Fed. That is very hard to gauge ex ante.
    2. Inflation will probably not be limited to the USD. Other central banks have also engaged in substantial “quantitative easing.” Esp. UK, but other countries as well. Moreover, other CBs would be under tremendous political pressure to inflate so as not to give advantages to US exporters.

    The ProfessorComment by The Professor — April 6, 2009 @ 9:47 pm

  3. Why TIPS and not platinum/gold/silver?

    Comment by Matt — April 7, 2009 @ 2:09 am

  4. Matt–

    Precious metals add to much volatility to your portfolio. Their prices are driven by myriad factors other than inflationary expectations. Platinum and palladium in particular, in part thanks to erratic Russian supplies, and perhaps manipulation. TIPS give you a better hedge against inflation risk, to the extent that CPI reflects the price of your consumption bundle.

    The ProfessorComment by The Professor — April 7, 2009 @ 9:02 am

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