Monday, July 20, 2009

No Inflation Here

If you have had your fill of Rosie for a while (not sure how that is possible, but a big hypothetical if), here is a wonderful piece by Hoisington Investment Management Company. Some great monetary and fiscal insights and a well-argued and coherent discussion on why there will be no inflation for a long time. Also lends credence to the theory that Gross very well may be spot on and the market is run by a bunch of herd-instincted, CNBC watching WOPRs.

The conventional wisdom is that the massive increase in excess reserves might eventually be used to make loans and reverse the economic contraction now underway, or that the velocity of money might increase. First, there is a very good
explanation for the surge in excess reserves. The Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits
from riskier alternatives to the safety and liquidity offered by the Fed. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess
reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). If this is the amount needed for transaction purposes, then this “high powered” money is not available for making loans and investments.

Second, velocity (V), or the turnover of money in the economy, is far more likely to fall than to rise. This is because V tends to fall when
financial innovation reverses downward. As this process continues excess leverage will eventually diminish and together they will lead V lower.
This process has already begun in the household sector.

In addition, the Fed needs an upward sloping supply curve to get the economic ball rolling. Today we estimate that the AS curve is flat. The reason it is in this perfectly elastic shape, rather than upward sloping, is that we have substantial excess labor and other productive resources. For example, in June the work week was at a record low while the U6 unemployment rate was at an all time high of
16.5%. No wonder wages are deflating. Further, industry capacity utilization was at a four decade low at 68.3%, while manufacturing capacity was at a six decade low for the longer running series at 65.0%. Indeed, when excess resources are extreme, the AS curve is likely to be not only horizontal, but shifting outward, meaning that prices will be lower at any level of aggregate demand or GDP. Thus,
even if Fed actions could shift the aggregate demand curve outward, which it cannot do under present circumstances, inflation would still be a long way down the road. Thus, theory and current evidence clearly point to deflation as the overwhelming economic risk.

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