Wednesday, May 5, 2010

Is there higher inflation for the future?

Econbrowser's analysis of the Fed balance sheet seems to indicate that inflation is going to be an outcome from having to unload all the assets that it has acquired in trying to flood the market with liquidity and subsequently aquiring equity stakes in the bailout. Slate sees a more benign outcome:

... As it guaranteed debt and swapped cash for all sorts of assets, the Fed's balance sheet grew—from about $850 billion in assets before the crisis to about $2.3 trillion this spring. ... Each week, the Fed's H.4.1. publication gives a snapshot of the Fed's balance sheet. Table 10 provides the headline number: $2.334 trillion on April 28, down $7.1 billion from the week before. ... as I [Daniel Gross] documented in a recent column, that's all on a glide path to going away. The closing of the sales of Alico and AIA will return $50 billion to the Fed, and the Maiden Lane vehicles are generating sufficient income to pay down the debt extended to them—and then some.

Meanwhile, many of the market and asset guarantees that the Fed put into place in '08 are expiring. At its peak, the commercial paper funding facility, which guaranteed short-term corporate debt, held more than $300 billion. Now its balance is down to zero. The Term Asset-backed Lending Facility, or TALF, which was started in late 2008 to revive the market for loans backed by assets like car loans and credit card receivables, is closing to new business in June. TALF's balance stands at $45.3 billion, down from more than $48 billion in March. Why? Some of the three- and five-year loans guaranteed by TALF have already been paid off. This balance should shrink to zero by 2013.

... The largest single item on the Fed's balance sheet is the $1.1 trillion in mortgage-backed securities it has acquired since the meltdown began. These are bonds issued by Fannie Mae and Freddie Mac and guaranteed by the U.S. government. The Fed has signaled that its buying campaign is over. And while the mortgages backing these bonds don't mature for 15 to 30 years, many of them will be disappearing from the Fed's balance sheet in the near future as people pay down, prepay, refinance, and sell homes. An informed analyst might presume that some $200 billion of that portfolio will mature or be paid down by the end of 2011. And as those bonds disappear, the Fed is not replacing them with new ones.

The bottom line? The Fed wants to get the junk off its balance sheet and return to a situation in which it has about $1 trillion in assets, the lion's share of them in the form of government bonds. To do so, it will need to rid itself of about $1.3 trillion in assets. That's a lot. But when you add up the components of the balance sheet that are shrinking, the task doesn't seem quite as daunting. By the end of 2011, by my rough calculations, at least $300 billion of the Fed's current assets will be gone with a substantial additional amount on the way out—and all without the Fed having to stage a huge sale of assets. The Fed will be left with a large portfolio of government-guaranteed mortgage-backed securities and the difficult chore of weaning the economy off its diet of rock-bottom interest rates.

Nouriel Roubini disagrees (not with Daniel Gross) - he still sees inflation as a problem not from the Fed's balance sheet but from public debt:

... we are seeing a massive "re-leveraging" of the public sector with budget deficits on the order of 10 per cent of GDP. The IMF and OECD are projecting that the stock of public debt in advanced economies is going to double and reach an average level of 100 per cent of GDP in the coming years.

... If you are a country like the US, the UK or Japan that can monetise its fiscal deficits, then you won't have a sovereign debt event but high inflation that erodes the value of public debt. Inflation is therefore basically a capital transfer from creditors and savers to borrowers and dissavers, essentially from the private sector to the government.

While the markets these days are worrying about Greece, it is only the tip of the iceberg, or the canary in the coal mine of a much broader range of fiscal crises. Today it is Greece. Tomorrow it will be Spain, Portugal, Ireland and Iceland. Sooner or later Japan and the US will be at the core of the problem, shaking the global economy.

We need to recognize that we are in the next stage of financial crisis. The coming issue is not private-sector liabilities, but public-sector liabilities.

Yet there are plenty of naysayers as well. For instance, Mike Kinsley reports:

Every economist I admire, from Paul Krugman and Larry Summers on down, is convinced that inflation will remain low for as long as we can predict. Greg Mankiw, who was George W. Bush’s economic adviser, has examined the evidence in his New York Times column and concluded that a return of debilitating inflation is pretty unlikely (although “current monetary and fiscal policy is so far outside the bounds of historical norms” that who can say for sure?). Krugman has charged that inflation fearmongering is a nefarious Republican plot. The Congressional Budget Office (usually known by its nickname, “the nonpartisan Congressional Budget Office”) projects inflation rates of less than 2 percent for the next decade. Some say the real danger is the opposite: deflation, or prices (and wages) going down across the board.

Is this an example of the failure of economics or a failure to communicate? If Mankiw and Krugman can agree then there must be something to it.

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