E-piphany

Foreword: I need your help! Please read to the bottom of the post and participate in the poll: the bigger the sample, the better!

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Stocks did actually decline today. The decline started last night; the conventional explanation is that investors were discouraged by the Fed’s dour outlook (the Bank of England also cut its growth outlook, today). Volumes were light (although Wednesday’s volume was the highest of the month), but the vector was clear and the arrow pointed downward. Bounces were feeble, although that is doubtless due to the fact that it’s August. The S&P index fell 2.8%, and the VIX rose to a level last seen in mid-July.

While I think the proper level for the indices, if the Fed is going to stoke inflation, is lower (the result of lower earnings from slower growth combined with lower multiples associated with higher inflation), I don’t think investors were selling because of a fear of inflation. They sold because they’re worried the Fed may be right about deflation. Look at the dollar: it rallied hard, despite a very weak Trade report (more on that in a monent) that would ordinarily cause the unit to sag. Look at the bond market, where yields on the 10y note fell to 2.69% despite a $24bln auction and the 30y yield fell to 3.93% as well. And of course, look at the inflation curve where inflation swaps dropped 4-5bps across the curve.

So the equity market had the “right” response, but for the wrong reason. Deflation isn’t our problem, inflation is (or will be, if the Fed pursues QE as they seem bent on doing).

The Trade Balance was much worse than expected, and not just because imports were higher. If the deficit is expanding because we are importing more, that’s not so bad because at least it signals domestic demand is okay. Imports rose 3%. But exports fell 1.3%, the worst performance in more than a year. Sputtering global growth is bad news for everyone. The big miss on the Trade Balance for June implies that the GDP figures for Q2 will need to be revised substantially lower (recall that GDP = C + I + G + (X-M) ). I haven’t seen the extent of the revisions yet, but I noticed that one shop lowered not only their Q2 figure but also their Q3-4 figures since it is harder to envision a strong second half if the first half was already fading.

There has been building a not-so-subtle tension between the bond guys, who apparently saw weak growth ahead and priced yields accordingly, and the equity guys, who saw sunny skies, kittens, and hugs. It looks like that disagreement is being resolved right now in favor of the bond guys, although it helps that the Fed is going to be buying about $18bln in Treasuries and TIPS (mostly the former) over the next month.

This is about more than just Fed buying, however. Nominal yields can be low either because inflation expectations are low or because real yields are low, or both of course: the Fisher equation says (1+n)=(1+r)(1+i), where n is the nominal yield, r is the real yield, and i is expected inflation over the horizon. In the teeth of the crisis, in late 2008, real yields were very high and implied inflation very low; when nominal yields plunged it was mostly because expected inflation was dropping as the market priced in deflation. Real yields remained fairly high, partly because deflation makes for pretty high real yields.

But now, real yields have fallen to within a whisker of the all-time lows at the 10-year point (see Chart, source Bloomberg). They reached those lows during the Bear Stearns crisis, when the extent of the housing slowdown was becoming apparent.

10-year real yields are near all-time lows

Real yields are not that low again because the Fed is restraining nominal yields. The Fisher equation implies that movements in nominal yields are an effect, not a cause, of movements in real yields and inflation. Real yields are low right now because there is slack demand for capital, and they are a symptom of economic malaise. Low real yields will also be part of the cure, of course, as an automatic stabilizer in the same way that low oil prices in a recession help stabilize growth. But the bond market is telling us that investors think real growth will be low not just for a year or two, but for a long time.

Thursday’s Initial Claims data may recall this to mind. Remember that last week saw a wholly unexpected jump to 479k. The consensus expects a retracement to 465k, which strikes me as a little timid if economists still thought we were in an improving trend. Evidently, confidence in that fact is wavering.

Damage has been done technically to the stock market, and I expect a return to the 1040-1050 level on the S&P at least and perhaps a deeper pullback than that. Bonds may be getting a bit ahead of themselves, but it is hard to believe that we won’t see a re-test of the 2008 lows near 2.05% on the 10y note. That is a change for me, incidentally. I still think the secular worm has turned, and we will ultimately see higher rates, but bond bears are on the run for now with the strongest seasonal period of the year (Sep-Oct) approaching quickly.

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I want to ask a favor of readers of this column. I have been working on a paper recently and I want to test a hypothesis I have. I’d like to take a (very unscientific) poll about your perceptions of what inflation is like for you. Below you will find a poll I’ve created, and I’d appreciate it if you’d take a few minutes to reflect on your answer and to record your perceptions. To quote Count Rugen in The Princess Bride as he begins to torture Wesley: “and remember, this is for posterity so be honest.” I appreciate your time. If you’d like to help further, feel free to post the direct URL for this poll – http://poll.fm/25auj – to friends, family, and Facebook. Thanks a lot!

The Fed performed as was generally expected today. After James Bullard’s article came out in a pre-print last week, it was fairly clear the Committee was planning to edge towards QEII. By announcing that the Open Markets Desk would roll over received MBS and Treasury cash flows into the purchase of new Treasuries only, they are moving one step closer to explicit monetization of the debt. It was a necessary step – before they grow the balance sheet, they must stop shrinking it – and the logical first increment.

Buying Treasuries is qualitatively different from buying MBS. By buying MBS, the Fed is assuming from the prior owner of the MBS the risk of non-payment, and providing cash to the seller. The purchase removes to the government the credit risk, and has the same effect on the economy as if the homeowner paid off the mortgage with a pile of money he found in the mailbox one morning. It adds liquidity, but mainly it supports mortgage prices. Buying $100bln of Treasuries, on the other hand, is functionally equivalent to printing $100bln in cash and sending it to the U.S. Treasury to spend. The only difference is the order of transactions; instead of being (1. print money 2. buy services with cash) it is (1. issue bonds for cash 2. buy services 3. replace bonds with cash in the accounts of the bondholders). It is as if those bonds had never been issued – it is as if, in other words, the services rendered to the government in exchange for those bonds was paid for instead by currency hot off the presses.

Not surprisingly, bonds rallied on the news. The bond market has been steadily marching higher (10y yield down to 2.76% now), partly on the belief that something like this was inevitable. Bond buyers are going to increasingly feel bulletproof until one day they are not.

Equity investors always feel bulletproof, so the as-expected release sent stocks leaping as I figured they would. To be sure, indices had sold off in the morning so the afternoon jump still left the S&P -0.6% on the day. Stocks should not be going up on this. The economy is weak, and that is bad for earnings. The Fed is trying to inflate, and that’s bad for multiples. There is a widespread-enough myth that inflation is good for stocks that I expected a rally on “QEII news,” and there will be some knee-jerk buying because interest rates are falling, but in this case they are falling because of a large buyer stepping forward to make purchases for non-economic reasons. I am not sure what the catalyst will be for the next leg down, but it is getting overdue. If stocks can’t get up and over the June peaks in fairly short order, and on something better than the anemic volumes we have been seeing, then gravity will begin to take hold I think.

I was a bit surprised that the Fed did not remove the “extended period” language from the statement. Perhaps that was left for step two in September so that step three, outright balance sheet expansion, can happen in November as I expected.

The Fed initially didn’t say what Treasuries they will be buying, other than to say “long-term” Treasury securities, although the NY Fed later added more color (see below). I have said it before and I will say it again: if the Fed wants to drive up inflation expectations, it should buy TIPS and force the breakeven inflation rates wider. By buying Treasuries, they have been and will be forcing breakevens lower, which all else being equal will cause investors to think the market is pricing in less inflation. In this case, they’ll be buying TIPS but not enough, I’ll wager.

Oh yes, on inflation the Fed had this to say:

Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

I guess we’ll see, won’t we? The monetary policy makers at the Fed, ironically, are all Keynesians now. Sure, if M2 continues to grow at a 2% pace, then we’ll get neither growth nor inflation, but it will have nothing to do with resource slack. The Committee clearly wants money supply to start growing more briskly, however, and if they pursue QE with enough enthusiasm, they’ll get inflation no matter what the resource slack.

Late in the day, The ABC Consumer Confidence number jumped to -47. I only mention that because the decline last week to -50 was cause for remark as the second-lowest figure on record, so to be fair I should report the improvement.

Tomorrow, the monthly trade balance numbers and monthly budget statement are the only data on tap. However, the New York Fed will publish at 3:00 a schedule of dates, security types (nominal or TIPS), and maturity date range for their purchases over the next month. The Desk says that it will be concentrate on 2y to 10y maturities (not exactly “long-term” if they’re buying 2-year notes) but will be buying across the whole curve.

Oh yes, that is an interesting point as well. The 10y-30y spread today widened about 6bps. This is not the first time the 10y-30y spread has widened. As the chart below (Source: Bloomberg) shows, the 10y-30y spread has been going ballistic for a month and a half. 10s have also been getting richer relative to the 5y lately, although that is partly a function of the compression of the yield spectrum (5y notes are at 1.45%, so at some point they will rally slower even though the curve usually steepens in a rally).

Someone had nice timing, buying what were already all-time wides.

I am not saying that someone knew this was going to happen with the Treasury buying 10y notes and not buying as many 30y notes. Perhaps it was great analysis. But if no one smells the hand of a certain Wall Street institution that has previously been involved in trading inside information regarding Treasury issuance patterns…

As we look to Tuesday, it is easy to recognize that the FOMC meeting is the signal event of the day. It may also be the signal event of the year, and even more than that if there is any significant change that results.

I believe it is fairly likely that the Committee will make some important changes to the statement at this meeting. The article by James Bullard, released a week ago or so (“The Seven Faces of ‘The Peril‘”), was interestingly timed. It was a “preprint” of the article which is to appear in the St. Louis Federal Reserve Review in the September/October issue. I can’t think of many reasons to publish a “preprint” only a week before an FOMC meeting unless there was already some fairly in-depth discussion about it going on around Fed circles (if there wasn’t before, there surely is now!).

To review, the article concerned Bullard’s contention that the decision by the Fed to not only lower rates to zero but also to telegraph that rates would remain so for an “extended period” runs the risk of causing the economy and monetary policy to become trapped in a stable equilibrium of low rates and mild deflation, as has been the case in Japan for the last couple of decades. I have written before that in my opinion, the Japanese experience is easy to avoid although if you don’t like the medicine – in this case, fairly aggressive money printing – then sure: you will stay sick.

Bullard recommends that we take this medicine. He argues that the Federal Reserve should not only remove the “extended period” language, which (in his view) causes expectations to decline and to trigger the stable lower equilibrium, but also to embark on quantitative easing again. However, he argues that instead of buying mortgage securities the Fed should buy Treasuries. The difference is that the latter is functionally equivalent to turning on the printing presses, while the former is not.

I don’t think it is coincidence that the Bullard piece was released when it was, although I suppose you could argue that it could raise inflation expectations by itself. Now, I don’t think the Fed will announce QEII tomorrow – and that may be very disappointing to equity investors who pushed stocks higher today so that we are again very close to the June 21^st highs. I believe, though, that the Fed will remove the “extended period” language; by doing so after the Bullard piece has been circulated, they hope that the reaction which otherwise would have occurred (a big selloff and a pricing of near-term tightening) will be short-circuited since the market will understand that the change more likely means easy policy rather than tight policy.

All of this reinforces what I have argued for years and years, including in my book. Fed “openness” is an absolute disaster that causes investors to become overconfident and complacent about monetary policy, inducing more leverage and higher risk-taking. Consider the quirky decision tree the Committee faces. If they say in the statement anything about deflation (or “an unwelcome decline in prices”), they will telegraph that perhaps we should be worried about deflation. And if they don’t say any such thing, investors may well worry about deflation because they don’t mention it and investors are worried the Fed might not “get it.” They probably want to remove the “extended period” language, but by doing so they might accidentally imply they are tightening soon…or, following the Bullard piece, they might imply they are about to embark on QEII soon.

What a mess, and another great example of why it would be good for them to be quiet and let us all assume they’re working on it. “Transparency” is one of those things that always sounds good in theory but may not be so great in practice. If you don’t believe me, try being “transparent” to your spouse about how she really looks in that dress. Sometimes, silence really is golden [although not in my case, dear, because you always look stunning].

The question for me is not whether the Fed does or says something different. They must, or I predict stocks will get killed with disappointment. The question is how fast they actually do something. I don’t think it will happen tomorrow, and probably not at the September meeting unless the data turns south rapidly, but likely not long after that. The FOMC would probably like to wait as long as possible to see if any deal is forthcoming about extending the Bush tax cuts and diverting the fiscal asteroid heading towards Earth. They can’t wait much longer than the November 3^rd meeting to make QEII happen, given the lags involved, and such a delay would also allow them to evaluate the results of the mid-term elections (November 2nd)  and whether the supposed populist tide of fiscal conservatism is real or not. Anyway, that’s my educated guess.

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As an aside, some people might wonder why I am so worried about fiscal retrenchment when I am ordinarily very vocal about the opposite: that fiscal stimulus doesn’t work in the long run. If that’s true, then isn’t the opposite also true, that fiscal restraint doesn’t cause damage in the long run?

It isn’t that I am a Keynesian only in the negative way. Fiscal restraint is good in the same sense that spending increases are bad. Tax cuts are inherently better than spending increases, because the latter increases the amount of resources consumed inefficiently by government, but both tax cuts and spending increases just move money from time A to time B.

Big changes in the fiscal balance, though, definitely affects the short run trajectory of growth, and I’ve never claimed otherwise. The stimulus plan caused growth in ’09 at the expense of growth in ’11 (or later, if the Bush tax cuts are extended), and cutting the deficit now would trade contraction in ’11 for somewhat more growth than otherwise would have happened in ’13. The danger of this is twofold. First, we have seen that it is very unusual for deficits to be reversed because it is easy to vote for hedonism but hard to vote for asceticism. Second (and more relevant here since it actually looks like asceticism is gaining adherents) is that if the short-term nature of the fiscal policy action isn’t understood it can lead to bad monetary policy action. That is to say that the proper response to the coming fiscal restraint, from the monetary policy side, is probably nothing since the earlier stimulus wasn’t met with a counterbalancing tightening of policy.

In this case it will lead to a technical double-dip (since we were technically ‘expanding’ mostly thanks to G in C+I+G+(X-M)) and this is likely to have serious repercussions on the Hill. That’s not an ant hill we want to kick, because unlike a normal ant hill Congress doesn’t typically get organized and do smart things to lessen the damage – they get disorganized and do dumb things. They’re more like anti-ants.

Bonds set back (2.95% 10y notes), and stocks rallied (0.6%), on the marginally unimpressive news that the ADP employment indicator was +42K rather than +30K expected and the ISM Non-Manufacturing Composite rose to 54.3 rather than falling to 53.0. That’s a pretty slender reed for optimism, but volume was light and this is probably more likely to be modest pre-Employment positioning than anything else.

I was more impressed with the news that China is making its banks “stress test” for a 60% decline in home prices rather than the 30% they had previously demanded. Of course, China is anything but a transparent democracy, so we won’t know whether the tests were conducted rationally or whether it means anything at all, … oh, wait a minute, that’s pretty close to the EU test. Forget what I said about transparent democracy!

In the “amusing news” department was this nugget: the NY Fed is looking to put back to the issuers ‘ineligible mortgages’ they acquired in non-agency RMBS and CDO securities when they rescued AIG and cleaned Bear Stearns up for its shotgun wedding to JP Morgan. As an investor in these securities, the Fed of course has the right to put back loans that weren’t eligible for the structures they were embedded in (this is typically a pretty small number), but the amusing part is the context of the big losses the Fed is taking. Remember, when the Fed created the first Maiden Lane entity (the three entities collectively hold $69.1 billion in assets), they made JPM guarantee the first $1bln in losses. They then declared that this made any loss on the portfolio extremely unlikely, a legal prerequisite for the Fed actually buying them. At the time, bond market people snickered because the idea that $1bln would cover the losses on $30bln of junk was ridiculous. Now the Fed is looking for nickel recycling refunds to lessen what will be substantial losses. Surprise? Not really, we all knew it was a dumb deal and a way for the Fed to put money in JPM’s pockets, but money is just an accounting entry to them anyway.

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A couple of readers/email correspondents provoked thoughts from me (which is no mean feat) that I wanted to share.

First, in responding to someone who had made the usual observation that there is too much incentive for the government to cook the books on inflation: I have often observed that the methodology is very transparent, and has been widely debated and discussed publicly. But here is another argument for why it doesn’t make sense for the government to do that, in the long run. If CPI was significantly understated, then it would ultimately only have a short-term effect. If CPI told us inflation was 1% when in fact it was 4%, then the Fed would routinely add too much liquidity (thinking inflation was in fact 1% and needed to be higher), and this would tend to cause inflation to rise anyway. So if the government is intentionally mis-reporting CPI, then the very fact that they did so would defeat the purpose. Unless, of course, you believe that not only the academics and professionals at the BLS, but also all of those at the Fed, are in on the Big Conspiracy…

The second thought was triggered by my old friend (and poet) AF, who queried whether there is a case to be made that bonds are in a bubble (you can read his comment to yesterday’s column “A Growing Disconnect” at the bottom of the page here). Now, I haven’t been sympathetic to the “bond bubble” view in the past, but I think the case is growing. An important component of any bubble is that investors need to believe (somehow) that they can’t really lose very easily, or not very much. “House prices never fall nationwide” (false, but widely believed during the housing bubble). Until now, there were not many people who believed that owning bonds was a no-lose situation, although there were a few. With the Fed now publicly discussing buying them – and in the past, Bernanke himself has reminisced about the period around WWII when the Fed simply set bond rates – it is plausible that someone might think “I don’t have a lot of upside, but with the Fed buying I don’t have much downside either.”

Plausible, and in the big picture likely to be wrong. But it might not be terribly wrong for a while.

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On Thursday, the main event (such as it is) is the release of Initial Claims (Consensus: 455k). Coming a day before Employment, this is unlikely to be a market-mover. Geithner and Yellen will be on the tape at different times, the former at a briefing for the Social Security and Medicare trustees (and you thought your job wasn’t fun?) and the latter giving remarks at a hearing on the Home Mortgage Disclosure Act. Neither is likely to move markets.

I am intrigued, and perhaps concerned, by the growing disconnect between stocks and bonds. The 10y yield fell to 2.91%, only three basis points above its low yield of the year, and the September Note futures contract went to a new high. Contributing to the fixed-income rally was news that GM’s sales in July rose 1.5% and Ford’s fell 0.7%, when analysts were expecting 10% gains (It appears that perhaps GM didn’t need to stay open during the usual retooling period after all!), flat Personal Income and Spending data (near expectations, however), and a drop in Pending Home Sales when analysts had been looking for a gain. Late in the day, the ABC Consumer Confidence number matched the lowest print of the year at -50, only a little above the swoon lows of -54 in December 2008.

So bonds seem to be pricing anemic growth both currently and in the near future. And it is a growth story, for while TIPS yields are now negative out to the 5 year point, the inflation curve is rising and flattening. The chart below (Source: Bloomberg) shows 2-year inflation swap rates are at the highs for the last couple of months, which is certainly curious given all the talk of imminent deflation.

Rates aren't falling because of inflation expectations.

Indeed, I expect that real yields might go negative even further out the curve. At these yields, to be sure, TIPS become less competitive with real assets that have zero real return, such as residential real estate and gold. But do you remember how I pointed out that Gross, by declaring prices had outright fallen for two years, was pretending to be unaware that the effect came almost entirely from oil? Crude had fallen from 145.29 in July 2008 to 33.87 in December 2008, and we felt those repercussions in the price index for much of 2009. But now, oil is back above $82 and has risen $10 in the last month.

The dollar, whose strength in late 2008 helped fuel the deflationary pulse, replicated that feat in the first half of this year when the dollar index rose some 20%, from 74 to 89. It is back to 80 (see Chart, Source Bloomberg). The whiff of deflation you think you smell? Better sniff quickly, because it’s going fast.

Dollar strength is turning into weakness, just as people get worried about falling prices.

We can go deeper than these markets, though. The chart below (Source: Board of Governors, adjusted by me) shows commercial bank credit growth. I first started running this chart in 2008, when the growth rate of credit turned negative year/year for the first time since data begins in 1973. (As an aside: I adjusted for the fact that Goldman and Morgan Stanley abruptly became commercial banks during the crisis, causing a huge spike in commercial bank credit merely because the credit was re-classed and keeping the official rate of credit growth positive for a year).

Bank credit may soon stop contracting so vigorously!

This has been a nothing-new-to-see-here chart, with the same bad news, for the last few years. But it is starting to look as if commercial bank credit may be turning the corner and … well, anyway, it may stop contracting, and that’s the first step toward stable or higher money velocity.

These things are all happening while, and perhaps because, the “Fed Mulls Symbolic Shift” according to the Wall Street Journal. The symbolic shift in question is to take the cash flows from its rather ample bond portfolio – the coupons and maturity flows – and use it to buy more bonds. The Fed otherwise would be letting its portfolio shrink slowly, something that the guy in charge of the System Open Market Account (SOMA), Brian Sack, thought wasn’t any big deal. Dr. Sack said back in March that even if the Fed were to actively sell the securities in SOMA, rather than just let the mature, it would have little effect on market rates if it were done slowly. (I was skeptical: see my analysis here).

Apparently, either the FOMC isn’t so sure of that, or they feel they can’t take even a small chance that it does. Moreover, as I have suggested recently, if they are actually moving toward buying more securities it would seem a good first step would be to start reinvesting the existing cash flows as they arrive.

Stocks did decline today, but only 0.5%. Either the equity market isn’t reading the same thing that the bond market is, or there are people investing in stocks because they believe equities have inflation-hedging attributes. In the long term, they may, but as the chart below illustrates (Source: Robert Shiller, data from Irrational Exuberance available at http://www.econ.yale.edu/~shiller/data/ie_data.xls) the move from low inflation to either inflation or deflation is a negative valuation shock.

More inflation means lower valuations.

Inflation right now is just about in the sweet spot for valuations. If inflation were to go to, say, 8%, then the 17-18x earnings multiple we expect would go to a 10-12x multiple. That 37% decline in valuation will overwhelm any inflation-hedging properties of stocks for a while.

Moreover, I would be willing to guess that inflation in the context of strong growth is what equity owners are hoping for. The negative yield of TIPS suggests that, rather, what may be on offer is inflation in the context of weak growth. I shouldn’t harangue the equity guys. The low volumes suggest that the current rally isn’t exactly a stampede, although it could become one at any time I suppose. But in general, given a chance to bet with the bond people or to bet with the stock people, I generally go with the bond people. I would go with the TIPS people, but there still aren’t enough of us.

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Wednesday’s data includes the ADP cut at the jobs data (Consensus: 30k) and the ISM Non-Manufacturing Report (Consensus: 53.0 from 53.8). I suspect the former is more important.

A reminder: my book is still on sale via this link! Incidentally, I have been advised that I have chosen boring quotes from the book for that teaser page…I will find something more interesting to say there, but for now just ignore them – the book is better!

Friday’s release of the advance Q2 GDP figures, along with the benchmark revisions, will be cause for celebration … if somewhat subdued celebration. GDP grew at a 2.4% annual rate in Q2, marking the fourth quarter in a row of positive growth. The economy, that is, has been expanding for a full year. Critics might point out that real domestic final sales grew a fairly unimpressive 1.3%, and that overall growth has gone from 5% to 3.7% to 2.4% over the last three quarters even including the inventory building and the ample fiscal stimulus. Really mean critics, the kind that doesn’t get invited to parties, might observe that for all this growth and all this stimulus, the Unemployment Rate is unchanged from a year ago (at 9.5%), and expected to rise in this week’s report.

The GDP price index, expected to be +1.0%, was actually +1.8% although the core domestic price index was better-behaved at +0.9%. The Employment Cost index was +0.5%, a tick higher than expected with wages +0.4% and benefits +0.6%. The ECI is +1.8% over the last year, which is above the 1.5% trough rate experienced for 2008Q4-2009Q4.

The Chicago Purchasing Manager’s Index was much stronger-than-expected at 62.3 versus expectations for 56.0. My suspicion is that the non-shutdown by GM may have positively affected parts suppliers in the Chicago area. I don’t know how they seasonally adjust the Chicago PMI, and nobody mentioned that effect, but I would not be surprised to see it settle back next month. Moreover, I would not necessarily expect such a strong showing from the broader ISM report, due on Monday (Consensus: 54.0 vs 56.2), which was expected to soften but now probably has some higher “whisper number” attached.

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I was in a conversation this weekend with a reader of this column, and in reprising the general outlook we hit upon several observations that I think are worth making here about the lessons from Japan.

The first concerns the buying of bonds by monetary authorities. St. Louis Fed President James Bullard last week raised the specter of further Fed purchases in his discussion of how to avoid “The Peril” of Japan’s lost couple of decades. One complaint about this sort of policy is the obvious: by adding lots of money to the system, it can cause inflation (precisely what Bullard is trying to do, of course). But other people, pointing to Japan, say that “buying bonds doesn’t work. Japan never managed to generate inflation.

If this is true, then there is a wonderful opportunity staring us right in the face. If the Fed can buy all the bonds it wants, and not generate inflation, then we should be actively encouraging it to do so. Why? Well, if the federal government can spend trillions on all sorts of new programs, and have the Fed buy the bonds, and not have any ill effects, then why the heck shouldn’t we do that?! We can have our cake and eat it too. We can have tax cuts and profligate spending, and just have the Fed make up the difference. In fact, if there is any chance that this is the case, it is irresponsible to not try it. Everyone could be happy.

Now, I think most people are justifiably concerned that this sort of free lunch probably cannot exist, and for good reason. Everything about theory suggests that pursuing this policy would cause inflation. And we’re pretty darn confident in that theory, or as I said this would certainly be worth trying!

But back to the second objection, then: “Japan has been unable to arrest its deflationary tendencies.” My response to that has generally been dismissive, that they merely haven’t tried hard enough. In my previous comment, I said it was basically a question of dosage, and Japan never applied much of a dose.

Why is this so confusing to people? Why do people simply look at Japan and shrug helplessly? It sure looks like Japan tried very hard; according to CIA World Factbook (here) Japan as of 2009 estimates is behind only Zimbabwe in the size of its debt as a percentage of GDP, at 189%. Surely, they have tried hard enough, and failed. Are we doomed?

Wait a minute! Debt as a percentage of GDP is the result of Keynesian stimulus, not monetarist stimulus. In fact, the monetary actions, first ZIRP (the “Zero Interest Rate Policy”) and then quantitative easing or QE, were tentative, diminutive, and late. Japan, in trying to arrest the deflationary cancer, tried a little bit of chemotherapy (monetarist medicine) and lots and lots of voodoo (fiscal stimulus). The patient has not recovered, and other doctors around the world are despondent. “Nothing has worked!”

Here’s an idea – how about trying more chemo, and cut back on the voodoo? It sounds crazy, but it just might work.

The record on fiscal stimulus is poor. A decade of fiscal stimulus failed to jolt the U.S. out of the Great Depression; it failed to bring Japan out of its own depression; and it has provided a short-term boost in the U.S. lately but the jury is out on whether there has been any lasting benefit (it seems not). The contrary case is also interesting: the retraction of fiscal stimulus following WWII didn’t exactly cause the economy to collapse – in fact, it boomed – and the running of fiscal surpluses in the 1990s didn’t seem to take the shine off that expansion one bit. The only reason that with this rotten record fiscal stimulus keeps getting an airing in policy circles is because (1) it certainly seems like it should work, and (2) witch doctors are scary.

Meanwhile, everywhere you see rapid money growth, you get inflation. And despite the booming economy in the 1980s and 1990s, inflation declined as the growth rate in money also declined. It is hard to untangle the cause and effect from all of these examples, but the track record of the different policies is pretty different. Chemo seems to save many patients, and voodoo seems to kill most of them. I think Bullard is right, and I suspect we will find out in the next year or two.

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One final note – an interesting link was sent around by one of the Wall Street inflation desks. It is a comic book-style explanation of inflation. It isn’t bad, and really explains a lot of nuances about inflation. It is produced by the New York Fed, of all places. The link is here.