Greg Ip used to be point guy on Fed coverage for WSJ. he is now head of US economy desk at the Economist Magazine. he is very smart guy. I met him last July as part of a US-focused research agenda I organized for group of our institutional investor clients (1 day in NYC, 2 days in DC). IT was clear from our meeting with him that he is fully invested in the conventional, mainstream inflation targeting model. i think this model is fatally flawed, but i still ended up following Greg's writings and blog posting for the Economist because he writes well and covers interesting topics. see recent commentary on jobs report in article titled "Where are the Jobs: Troubling trends behind the Falling unemployment rate" at following link: http://www.economist.com/node/18114537/print
What i want to talk about here is Greg’s recent blog post which I’ve copied below along with my comments I've added to his article in RED. my main point is this: Greg's blog post epitomizes the upside down thinking that is forced upon us when we use the conventional mainstream model using CPI as proxy for inflation. Ip is worried about making policy mistakes if we don’t understand various key points he highlights in his piece. What he completely ignores is “the fact” that inflation targeting is what got us into the mess we are currently in.
Inflation lessons from the Asian crisis
Feb 9th 2011, 23:01 by G.I. | WASHINGTON
FOR those convinced that America is on the verge of becoming Weimar Germany, the high price of oil and gold are exhibits one and two. Often forgotten is the fact that both are traded in global markets and reflect global, not American, demand. Failing to appreciate the distinction can lead to policy mistakes. Just look at 1998. Gold and oil are traded globally but when they are priced in USD, their price reflects USD currency debasement. Further it is critical to keep in mind that global demand for gold and oil is ultimately determined by Fed policy – especially in Asia because the Asia bloc is essentially pegged to USD, which means Asian monetary policy is by default Fed policy. the boom in EM is a result of easy Fed policy, which shows up in surge in FX reserves. FX reserves are high powered money! When the Fed prints money, the money shows up in Asian central banks, which ultimately means the Fed is literally injecting high powered money into these economies.
A financial crisis tipped east Asia into a deep recession in 1997-98, which spread to Russia and then the United States via Long Term Capital Management. To cushion the spillover to America, the Fed first aborted a nascent monetary tightening cycle, then actually cut interest rates. It could do so in part because collapsing Asian demand crushed the price of oil, sending headline inflation below 2%. This was beginning of the Greenspan put. As long as CPI was considered low, the Fed had green light to temporarily flood markets with liquidity, which is what it did following collapse of LTCM. i emphasize the word "temporary" here because ultimately USD conditions kept getting tighter through 2001 as evidenced in gold price which kept declining through 2001 when it hit low of $260.
We now know that between cheaper oil and the Fed’s rate cuts, the Asian crisis was ultimately a positive for an economy already operating below 5% unemployment. Growth, and with it the stock market, went into overdrive. The result was the Nasdaq bubble. This is one narrative. Another narrative based on the gold price is this: the Fed accommodated global liquidity tightening beginning in 1996 coincident with Greenspans irrational exuberance speech. Tight global liquidity literally triggered the Asian crisis by tightening access to liquidity for over-leveraged Asian borrowers, such as Finance One in Thailand.
The surprise demise of Finance One in Thailand led to panic capital flight and forced lending calls by foreign lenders who worried that other Asian credits would default. It is no coincidence the Asia Crisis followed close on heals of gold price peaking in 2006 and declining into Greenspan's well documented / infamous concerns about a nascent equity bubble in the US.
My alternative "gold price" narrative is this: the Fed triggered the Asian crisis by either actively or passively draining dollar liquidity from markets. Greenspan was worried about equity bubble in the US and therefore he welcomed USD deflation! The Fed cut interest rates following collapse of LTCM, but monetary conditions remained tight from 1997 to 2000 as reflected in declining commodity and gold prices.
Tight USD money conditions actied to exacerbate the tech bubble by encouraging inflows into non-physical tech related internet stocks as physical assets deflated in value thanks to USD deflation. The difference between the Great Recession of 2008 and the post tech bubble bursting environment is that the tech bubble burst into a five year global deflation cycle!!! the Fed could thus reflate / debase USD with impunity.
Micro vs Macro bubbles and Systemic Risk
The tech bubble was what I would call a “micro” bubble. it wasn’t a result of easy money; in fact it was paradoxically the case that tech stocks benefited from deflationary money conditions as evidenced by declining price of commodities and gold during period from 1996 to 2000. Who wanted to put money into natural resource stocks during this 1997-2000 period? The tech bubble wiped out more wealth than the sub prime crisis, yet sub prime was ultimately a “systemic” crisis because it was coincident with an economy wide bubble fueled by easy money (clearly evidenced in gold price boom from $260 in 2001 to $900 in 2008 ahead of Lehman collapse).
There was only short recession following dot com bust and no systemic implications because we were starting from point of low point of global deflation. Today we are in a very different situation. The sub prime bust came on top of a global inflation!!! thus, when the Fed reflated into the bust it built another inflation on top of the previous one. that is where we are now. The Fed could reflate the economy with impunity following the dot com bust with an ultra low interest rate cycle because our starting point was a period of prolonged global deflation. The dot come bubble was a micro Asset bubble. the Great Recession resulted from a "macro" easy money bubble.
The surprise demise of Finance One in Thailand led to panic capital flight and forced lending calls by foreign lenders who worried that other Asian credits would default. It is no coincidence the Asia Crisis followed close on heals of gold price peaking in 2006 and declining into Greenspan's well documented / infamous concerns about a nascent equity bubble in the US.
My alternative "gold price" narrative is this: the Fed triggered the Asian crisis by either actively or passively draining dollar liquidity from markets. Greenspan was worried about equity bubble in the US and therefore he welcomed USD deflation! The Fed cut interest rates following collapse of LTCM, but monetary conditions remained tight from 1997 to 2000 as reflected in declining commodity and gold prices.
Tight USD money conditions actied to exacerbate the tech bubble by encouraging inflows into non-physical tech related internet stocks as physical assets deflated in value thanks to USD deflation. The difference between the Great Recession of 2008 and the post tech bubble bursting environment is that the tech bubble burst into a five year global deflation cycle!!! the Fed could thus reflate / debase USD with impunity.
Micro vs Macro bubbles and Systemic Risk
The tech bubble was what I would call a “micro” bubble. it wasn’t a result of easy money; in fact it was paradoxically the case that tech stocks benefited from deflationary money conditions as evidenced by declining price of commodities and gold during period from 1996 to 2000. Who wanted to put money into natural resource stocks during this 1997-2000 period? The tech bubble wiped out more wealth than the sub prime crisis, yet sub prime was ultimately a “systemic” crisis because it was coincident with an economy wide bubble fueled by easy money (clearly evidenced in gold price boom from $260 in 2001 to $900 in 2008 ahead of Lehman collapse).
There was only short recession following dot com bust and no systemic implications because we were starting from point of low point of global deflation. Today we are in a very different situation. The sub prime bust came on top of a global inflation!!! thus, when the Fed reflated into the bust it built another inflation on top of the previous one. that is where we are now. The Fed could reflate the economy with impunity following the dot com bust with an ultra low interest rate cycle because our starting point was a period of prolonged global deflation. The dot come bubble was a micro Asset bubble. the Great Recession resulted from a "macro" easy money bubble.
Today, we have the mirror image. Surging demand in emerging markets that are at or near capacity has driven up commodity prices at a time when America is awash in unused capacity. Buying gold as an inflation hedge makes a lot of sense, if you live in China or India.
Buying gold makes sense in USD because the USD price of gold is surging because the Fed is printing easy money – and money demand remains depressed. This is double whammy for fueling USD global liquidity – surging money supply and weak money demand.
Just as the plunge in the price of oil in 1998 did not signal deflationary pressure in America WHAT ARE YOU KIDDING ME GREG?!? the oil plunge was directly related to global ongoing USD deflation as expressed in falling gold price , its rise today does not signal inflationary pressure here, unless it works its way into expectations and wages, of which there’s no sign yet. (The 0.4% rise in hourly wages in January looks weird; for now, I’d discount it.) This statement may be technically true but it rests on erroneous definition of inflation as a rise in the general price level.
In fact, it could do the opposite: by draining more American purchasing power to overseas suppliers, higher oil prices leave less money to spend on stuff made in America. (America is a net food exporter so higher food prices are positive for American growth.) If the Fed were to tighten monetary policy today in response to Asia’s inflation problem, it could be the opposite of the mistake it made in 1998, compounding a deflationary shock at a time when the economy is significantly below potential.
Worrying about stabilizing CPI has us chasing our tails. We need a sound money policy. the Fed’s attempt to peg a certain stable price level is counter productive and dangerous. Relatively stable CPI inflation is the result of stable macro dynamics, not the cause. CPI should be allowed to rise and fall depending on productivity shocks. If productivity is high, then CPI would naturally be falling. To keep CPI artificially above zero with easy money policy is to sow seeds of credit boom bust cycle like we saw in 2005-2007.
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