The Great Reflation and its incumbent repercussions

Fed: A Monetary Solution For A Supply Side Problem?
By reneging on the mandate to target Inflation, the Fed and most Central Banks have made themselves subservient to Commodity speculators across the globe. As demand compresses interest rates are cut, as supply become an issue Speculators horde up on Commodities using leverage pushing inflation further.

Either way the belief rests, that the Fed will intervene to keep interest rates low. As Real Interest Rates turn negative, Investors have little reason to save depreciating dollars.

So who suffers? Wage seekers of all varieties and Rent seekers in Stocks.

While expected policy fallout of the credit crisis centers on changes to regulatory regimes, the likely monetary policy may have far greater macroeconomic consequences.

The credit crisis turned the spotlight on financial system excesses that allowed record levels of leverage to accumulate--including bank lending against risky, cyclically priced assets.

Policy responses have focused on regulatory reform. However, a greater policy impact may be a changed monetary policy framework.

Inflation targeting. A generation of central bankers has applied a doctrine of "inflation targeting," which uses a model-based approach:

--The "Taylor rule" sets a desirable inflation rate to maximize employment.

--The central bank uses interest rates to adjust growth toward the inflation goal, assuming there is a known equilibrium interest rate for stable full employment.

Asset prices. This model traditionally excludes asset prices, assuming that:

--these adjust around the equilibrium interest rate (i.e., are self-correcting);

--financial regulators should monitor leverage, not the central bank; and

--markets are better than central banks at identifying asset bubbles.

Recipe for failure. This approach became a victim of its own success:

--Financial markets became confident in central bank willingness to control inflation.

--This created profitable leverage structures within central bank model parameters.

--Leverage drove up asset prices--which, as they rose, provided collateral for further leverage.

Fed easing. As the U.S. Federal Reserve does not have an inflation target and couches its price stability mandate over a long horizon, it can allow inflation to rise without formal constraint.

Yet its loss of credibility fighting inflation allows wage demands to rise:

-- 1970s surge. Commodity--especially oil--prices drove inflation in the 1970s. However, when the Fed eased monetary policy to accommodate this, the general price level took off, and workers demanded compensation.

-- Tech bubble. When the Fed raised rates after its 2001-02 post-"tech bubble" easing, markets reacted by using increasing leverage to achieve desired returns, since they were confident the Fed could control inflation and keep interest rates low.

"Great reflation"? Historical trends might be categorized as: "great inflation" in the 1970s; "great moderation" in the 1980s-present; and a period of surprise inflation today, which might be christened "great reflation."

Globalization. Globalization may be helping lay foundations for reflation. A recent Bank for International Settlements paper sketches this relationship, considering interacting demand- and supply-side forces:

--High 1970s inflation was demand-driven (e.g., government deficits financed social programs) eventually leading to oil price rises and a wage-price spiral.

--The "great moderation" has been supply-driven, especially given Asia's rise as a low-cost producer. Globalization has expanded labor supply, introducing low-cost imports and restraining Organization for Economic Cooperation Development wage growth.

This suggests that central-bank inflation targeting in advanced economies has been relatively unimportant.


Safe Harbor Statement:

Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.

Nothing in this article is, or should be construed as, investment advice.