"Make it your mission to understand & invest wisely. Everyone has the potential to succeed in their search for true wealth & happiness & everyone can be successful in their pursuit of financial freedom." Contrarian Invest

Thursday, 20 September 2012

Should the US be worrying about inflation or deflation?

After the US Federal Reserve announced last week that it would be expanding its quantitative easing programme (essentially, its programme of buying assets other than short-term government debt) by purchasing large quantities of mortgage-backed securities (MBS), many commentators expressed concern that this policy would lead to out-of-control inflation in the United States.
At the same time, there are also a number of economists who are concerned that the US may succumb to a bout of deflation as growth remains slow and risk appetite subdued. Which of these groups is correct?

Growth, QE3, and inflation
The Fed announced its new mortgage debt purchasing programme, QE3, in the wake of a disappointing economic performance from the US; unemployment is still running at over 8% and GDP is growing by a tepid 1.7% annualised rate in the second quarter. Chairman Ben Bernanke said that the Fed would take, and keep taking, extraordinary measures to stimulate the economy until the monetary policy committee saw evidence of “broad-based growth in jobs and economic activity that generally signal sustained improvement in labor market conditions and declining unemployment.”

While some observers enthusiastically hailed the Fed’s plan to purchase $23bn worth of mortgage-backed securities by the end of September and to continue purchasing the instruments at a similar rate in months to come as a key step in reviving America’s economy, a vocal group of critics expressed reservations. Specifically, they said that by purchasing the securities and, in effect, printing more money, the Fed is setting the United States up for inflation problems in years to come.

There are arguments for and against this position. For example, currently, consumer price inflation in the US is low by historical standards – it has averaged about 3.8% a year since 1950, but in July was just 1.4% annualised, despite the fact that the Fed has pumped around $2tn into the economy through its various QE programmes over the last four years. Furthermore, as many economists have pointed out, although it’s unusual for the Fed to buy MBS, it’s perfectly normal for the Fed to expand the money supply. Although the current rate of expansion is a little high by historical standards, the country is emerging from a serious economic slump, and stimulus is warranted. Finally, a little inflation could be a good thing, helping indebted Americans and making US exports more competitive (by lowering the value of the dollar).

However, the fact that inflation is under control right now doesn’t mean that it won’t be a problem in the future. Certainly, the steady and continued rise in the gold price suggest that many investors are concerned about inflation, and maintaining rock-bottom interest rates while aggressively expanding the money supply isn’t a recipe for price stability. On balance, though, it seems that inflation is not as immediate or serious a threat as continued economic stagnation.

So much for inflation, what about deflation?
If inflation doesn’t pose a clear and present danger to the sagging US economy, what about the no-less-deadly deflation? Deflation, or falling prices, is a serious problem – just ask Japan, which has struggled to fight its way free of the drag of deflation for years.

While there is, as yet, no concrete reason to worry about deflation in America, this doesn’t mean it’s not a danger. Indeed, an interesting blog from author Harry S. Dent makes the case that deflation poses a very serious medium-term risk to the US economy. According to Dent, the unfortunate combination of a financial crisis and deep recession with an aging population means that America will inevitably face deflation in years to come.

He argues that as the Baby Boomer generation ages and retires, consumer spending in the US will slow, particularly because younger generations have been set back by the recession – home ownership, employment, even marriage are all unusually low among today’s crop of young Americans, which bodes ill for them as consumers.

This is an interesting argument. Certainly, it is a major concern that younger Americans are suffering disproportionally in this recession; studies show that failing to launch your career with a bang when you’re young can permanently hobble your economic success. It’s also worrying that such a large batch of Americans is due to start retiring – retirees generally consume savings rather than creating new wealth. This combination could indeed mean deflationary pressures for America.

However, America is not aging as rapidly as certain other countries (including China), and the Fed seems determined to ensure that deflation and sluggish growth are addressed. Deflation also doesn’t seem like an immediate problem.

The only real pressing problem facing America, then, is to get growing again. And the Fed’s latest move is a small step toward making that happen.

No comments:

Post a Comment