The Rise of Inflation Nations
At last week's Jackson Hole gathering, Ben Bernanke defended his case for further monetary stimulus to help the economy. It appears that QE3 is coming soon, possibly this month. I always believed that QE3 would come this year. The reasoning was based on how the Fed would react according to its dual mandate of price stability and employment maximization.
Short-term inflation data drives the Fed's inflation concerns. As a weakening global economy has recently driven down commodity prices such as oil, steel, etc., and the weak demand forces suppliers to discount, the current inflation picture looks benign. Even though these factors are short-term in nature, the Fed has at least an excuse to ignore the inflation risk. While there is usually an 18-month lag between monetary policy and its inflationary consequence, most central banks tend to emphasize current rather than future inflation. The justification is that a central bank like the Fed is smart enough to take back the excess money supply before inflation hits, though there is little evidence that this is true.
Bernanke calls the U.S. economy far from satisfactory. This is the right characterization. The current unemployment rate is 8.3 percent. This figure understates the difficulties in the labor market. The current ratio of employment to population over 16 is 58.4 percent compared to 62.9 percent five years ago. The current total employment is 4.2 million less than five years ago. Considering that the labor force normally grows by over 1 million per annum, there must be a lot of discouraged workers who have stopped looking for jobs and are not counted as unemployed anymore.
Monetary stimulus works through decreasing borrowing cost or devaluing currency. The former works if there are borrowers who respond to lowering the interest rate. The U.S. household sector suffers high indebtedness. Its debt appetite is low. The U.S. corporate sector is sitting on a record cash level and isn't likely to borrow and invest just because the interest rate is a little lower. The U.S. government suffers a high fiscal deficit and cannot increase it due to political deadlock. The dollar is strong due to the euro debt crisis and growth recession in emerging economies. QE3 may cheapen the dollar a bit, but won't be enough to make a significant difference because Europe is in recession and the growth rates in emerging economies are being halved.
QE3 will merely exaggerate bubbles that have emerged in some areas. The S&P 500 is close to an all-time high despite a weak U.S. and global economy. Internet stocks, for example, have valuations in the stratosphere. Manhattan flats are surging in price again. If QE3 makes a difference, it is through making bubbles. While there may be some gain in the short term, it will lead to bigger problems down the road.
ECB Will Buy More Bonds
Mario Draghi, the president of the European Central Bank (ECB), promised to do whatever it takes to preserve the euro. His statement turned around sentiment in the Italian and Spanish bond markets. There is little doubt that the ECB has to support these markets to hold the euro zone together. And Draghi's commitment works only if it is open-ended, i.e., it is willing to buy an unlimited amount to cap the bond yields for Spain and Italy. The ECB purchases are likely to be in the trillions of euros. As the ECB purchases such bonds from investors, a portion of the money would be diverted out of the euro zone. The resulting euro weakness will be the immediate transmission mechanism for inflation to hit the euro zone. Of course, the net increase in global money supply will inflate goods and services that have low price elasticity. Food and oil are good examples.
The ECB bond purchases, if big enough, can hold the euro zone together. It works through inflation to lower the real cost of social welfare in the crisis countries, like Italy and Spain. Cutting nominal expenditures has proven too hard to do. The main point is that ECB intervention works only if it creates inflation. While the ECB mandate is price stability only, the Draghi promise has put holding the euro zone together ahead of price stability. This is probably the path for the euro zone in the coming years.
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