Inflation, Radio FM and popular delusions

The current debate on the absolute need to create inflation is very intense. Advocates such as Krugman point to various benefits, not in the least the fact that the real debt burden is lowered. I believe it is a little bit more complex than that. Furthermore, adding more budgetary and monetary stimuli can create serious problems in terms of policy mistakes, this on 3 fronts :

1) In the seventies following two consecutive negative supply shocks ('73-'79), the wrong remedy consisted out an identical cure, being very active demand management (budgetary and monetary stimuli). At those occasions, the argument went that with the strong recession, idle capacity and output gaps were so huge that inflation was dead. After the facts however, it seemed that idle capacity and output gaps were far more smaller in size, idle capacity in fact being an idle concept ; As a consequence, the economy was operating closer to "full" capacity than was perceived by policy makers at the time. Even today, the debate is intense within the FED where some hawks (the minority) remind the camp of the doves (presided by Bernanke) that the non-accelerating inflation rate of unemployment is closer to 7-7,5%% than to 4,5- 5%.

2) The second potential policy mistake entails Quantitative Easing version 2.0 (QE 2) which is most likely in the cards, with business cycle sentiment turning the corner once again. With QE 1 already on the FED balance sheet, we know they will have a huge task on their hands in unwinding their positions of toxic assets to normal, taking some 3 to 5 years if it is the intention not to cause selling waves on fixed income markets. Adding QE 2 will most likely push the back-to-normal date further into the future. Also as is the case with point 1 mentioned above, the danger is that at that point in time, the FED is way behind the curve, with inflation and long term interest rates living already a life on their own. Briefly, exits are too little and too late.

3) To the extend your financing & refinancing is dependent on foreign buyers, you should be very careful in creating or fueling inflation expectations. The current attitude of China towards the US and its actions on UST holdings, inflation protected securities and gold is revealing.

The debate between the activists (Krugman) and the opposition can be wrapped up as follows. Suppose you like to listen to classical music while driving the car and have programmed your radio on Klara. Most of the time, your pre-programmed FM frequency will give a clear signal, from time to time it will produce some "noise" depending on the area in which you are driving. The traditional view is to leave it like it is and learn to live with the occasional "noise" on the frequency. The activist view is to fiddle around with the frequency knob in order to optimize the frequency reception. The problem with the latter is that by fiddling around, you end up listening to channels you absolutely want to avoid, being blown away by Sepultura instead of admiring Mahler's no5 Adagietto.

A final popular proposition is that governments can inflate their way out of debt. The debt ratio (debt/GDP) is pushed down because inflation increases the denominator. This is however not self-evident because in the process the nominator could get influenced as well. By creating inflation, the currency is undermined which will lead investors to ask for a higher risk premium. As long as nominal rates stay in line with inflation, there is nothing wrong. The risk is however that expectations on future inflation will be fed. Investors will push nominal rates further up to insure themselves with a sufficient risk premium. The nominal overshooting implies real interest rates moving up. This in turn will drive up debt cost in the future when existing debt is rolled over at higher real yields. Looking at today's real interest rates, we see that they are already at a substantial low level ; in the US for example, one needs to go to 5y maturities and longer to generate a postive real return. Following charts prove that in the case of Europe, the situation is identical:

Depending on the real interest rate shock over time and the amount of maturing debt to be refinanced in the short/medium term, the so-called "savings" you search to establish through inflation might be very disappointing indeed at the end of the day. At the same time, the tax base and savers' accounts have been punished, the confidence in the financial system and the currency have been damaged. A cost/benefit analysis on inflation as an exit tool is therefore far from straightforward.

Finally, some "clever" governments (eg Netherlands, Austria) seem to take profit from this low real interest rate environment by extending the duration of their outstanding debt. Looking at duration of the European government bond benchmark, it has gone up considerably over the past couple of months from 6 to almost 6,5.