Inflation: The strategy that dare not state its name

Marshall Auerback here with a few thoughts about the monetary policy end game.

Bernanke has to continue to make hawkish comments about inflation so as to avoid a complete blow out in bond yields, but the the dirty little secret is that inflation is the way out of the debt trap, along with dollar weakness. Both reduce the real cost of debt servicing.

But Bernanke is in a real policy cul de sac of his own making since he initiated Fed purchases of longer dated Treasuries. Low yields on bonds introduce a high risk of capital loss to investors if yields return to historical norms (think McCauley duration), and if investors cannot be sure they will hold the bond to maturity. The private sector will wish to raise their holdings in government bonds only if they perceive risk adjusted returns elsewhere are less attractive – yet this is antithetical to the very purpose of quantitative easing, which is to break the high liquidity preference of private investors by “trashing cash” and lowering the yield on default free government bonds. In other words, even before we get to the day when quantitative easing is removed, when investors face the likely renormalization of policy rates and the removal of implicit ceilings on government bond yields, there is a glaring inconsistency in the QE approach which no one seems to have noticed..

If government yields back up, either because private sector portfolio preferences are shifting toward riskier assets as central banks trash cash and suppress government bond yields, or because fiscal stimulus is helping “green shoots” take root and thereby encouraging riskier portfolio exposures, then mortgage rates are likely to back up as well, confounding any stabilization in housing sales.

Alternatively, if central banks step in to buy Treasuries and thereby contain the back up in Treasury yields, more professional investors are likely to conclude “monetization” is underway and they will try to increase their exposure to inflation hedges. The net result would be a likely rise in the relative prices of energy, precious and industrial metals, “commodity” currencies, and ag products and ag land – all of which, as inputs to final products, would tend to represent an adverse supply shock to the economy. In addition, raising the price of essentials like food and energy is more likely to crowd out consumer spending in discretionary items. Neither of these supply and demand effects are particularly supportive of an economic recovery.

Over to you Ed!

Edward Harrison here.  Basically, the Fed wants to inflate our way out of this depression – that’s the dirty little secret.  There is really no other policy choice because the mountain of debt in the United States is immense.  And I think Bernanke, Geithner and Summers have proven they are willing to do anything to reflate this economy and avoid debt deflation dynamics.

The problem with this inflationary policy response is that it invites a currency and asset revulsion.  Why do you think the Chinese have been talking so much about inflation in the west?  They are pretty unhappy about the prospect that quantitative easing will depreciate the value of their U.S. dollar assets. So they are looking to apply some pressure on the U.S.

But, policy makers are going to say one thing in public and to the Chinese and do another thing altogether different.  Hence, the hawkish talk by Bernanke in Washington this week about withdrawing liquidity.  Their hope is that the U.S. economy can right itself enough BEFORE the inflation becomes apparent and yields start marching upward.

But, the appetite for risk is fully manifest in U.S. markets, causing yields to back up and this is going to require an increasing “monetization” of the U.S. debt, making the inflationary policy that much more transparent.  While Marshall has already mentioned the flight to commodities and real assets as a likely response, you can expect the dollar to lose value in this scenario.

What the Chinese response will be is the $1 trillion in dollar reserves question.

Marshall Auerback


Marshall Auerback, has 29 years experience in the investment management business, serving as a global portfolio strategist for Madison Street Partners, LLC, a Denver based hedge fund. He also has also worked as an economic consultant to PIMCO, the world’s largest bond fund management group. He is a Fellow at the Economists for Peace and Security, a Research Associate at the Levy Institute, and a non-executive director of Pinetree Capital in Toronto, Ontario, Canada.