First, we turn to Peter Schiff, who tells Yahoo Tech Ticker that he expects China will need to unpeg its currency in order to fight inflation. Raising rates alone won’t do it, he says, because they’ll still be importing too many of our quantitatively eased dollars.
Source: Yahoo Finance – Tech Ticker, January 24, 2011.
Next, we turn to John Hussman’s always excellent weekly newsletter – this week’s edition is aptly named Sixteen Cents: Pushing the Unstable Limits of Monetary Policy. Take a wild guess what he thinks about QE!
He draws a VERY interesting – dare I say, contrarian? – conclusion about the results of an increase in the money supply:
If you look at the historical data, neither of these arguments hold a great deal of water. Rather, what seems to be true is that the strongest effect of an increase in the money supply is to drive short-term interest rates lower, thereby increasing liquidity preference (i.e. reducing velocity). So periods of very high growth in the monetary base are typically accompanied by nearly proportionate plunges in monetary velocity, without any strong effects on output or prices. As we’ll see below, that isn’t quite the whole story, but to a first approximation, the main effect of changes in the monetary base is to produce opposite and proportional changes in velocity.
I also liked this insight into the wealth effect:
Of course, QE2 has had additional effects on the financial markets, but these have not been driven by monetary factors. Instead, they are rhetorical, based on the view that somehow the Fed’s actions create a “backstop” that will prevent potential losses in risky assets. As Ambrose Evans-Pritchard has noted, “the Fed no longer even denies that the purpose of its latest blast of bond purchases, or QE2, is to drive up Wall Street, perhaps because it has so signally failed to achieve its other purpose of driving down borrowing costs.” Unfortunately, it is easy to demonstrate that the greater the volatility of a security or income stream, the smaller the “wealth effect” that can be expected from a given increase in value. Volatile dollars have less impact on consumption than smooth dollars, which is why housing values have historically had a much greater wealth effect than stock market values.
Intuitively I knew a housing boom had a greater wealth effect than a stock boom on the general populous – having just lived through each one! (Not to mention that a housing bust hurts a lot more than a NASDAQ crash.)
I always figured it was due to the ease and widespread ability to tap home equity – but the argument Hussman makes about lower volatility is an excellent one as well, and perhaps a larger factor overall.
Anyway back to his piece – after taking a look at velocity, he believes we could be in a very precarious situation with regards to inflation:
The disturbing fact about this, however, is that inflation dynamics can potentially become unstable when a massive stock of base money is being kept in check by very low interest rates. This is because small increases in interest rates from near-zero levels imply huge changes in liquidity preference and velocity. If those changes are not offset by opposite and proportional changes in the monetary base, strong inflation pressures are likely to follow.Historically, it has usually taken an extended period of such inflation pressures (sustained over 6-12 months) before the implied inflation pressures are actually reflected in price levels. Temporary differences between the actual and implied GDP deflator are not very informative unless they are sustained.
You can read Hussman’s full piece here (highly recommended).
Hat tip Dr. Evil for sending along these stories!
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