2015: A Year Without Inflation?

Just a couple of months ago, market pundits were still discussing the possibility that the anti-recessionary Quantitative Easing (QE) policy of the Federal Reserve Bank of the United States would lead to “raging inflation” in the American economy. Have they been proven correct?

Hardly. Health care cost inflation, for instance, continues to remain below 5%, where it has lingered for the past five years. And energy costs have actually plummeted this year, with the price of a barrel of crude oil falling by well over 40%.

The implications of such low inflation rates may be profoundly positive for the American economy. After all, low inflation rates tend to be reflected in low interest rates. And when bank loan rates are low, organizations can better afford to finance speculative projects with costs that are significant in the short term and benefits that can only be recognized in the relatively distant future.

Such projects often promote the long term competitiveness of the American economy. Do you suport investments in renewable energy technologies, for instance? Driverless automobiles? Drugs to cure cancer? These investments are not likely to pay off in the near future, but in an extremely low rate environment, more organizations may be willing to pay for such projects.

There is a risk, though, that inflation and interest rates might plummet below the “zero lower bound” and actually become negative in direction. That hasn’t yet happened in the United States on an annual basis; even though energy costs have been dropping significantly and the Consumer Price Index (CPI) declined by a nominal 0.3% in November 2014, the annual CPI remained at positive 1.3% through that month.

But what could happen if inflation drops significantly below zero? If consumers and businesses become convinced that prices will continue to fall over time, they could stop spending money today and delay their purchases and investments in order to wait for a lower cost future.

Such debilitating deflationary psychology has plagued the Japanese economy for two decades. The European Central Bank (ECB) is reportedly worried that deflation and its effects may soon strike the European Union as well.

So there is a very real risk that an American bout of outright deflation may derail its economic recovery. Nevertheless, if the upcoming year features very low (or no) inflation, the economy of the United States may continue to serve as the engine that drives global prosperity.

Global Banking: BIS Disses Our Political Leaders!

Have you heard of the Bank for International Settlements (BIS)? It’s the financial institution that serves as a global clearing house for most of the world’s major national banks. U.S. Federal Reserve Bank Chairman Ben Bernanke, European Central Bank (ECB) President Mario Draghi, and their colleagues on the BIS Board of Directors help the organization coordinate regulatory activities at the international level.

You wouldn’t expect the BIS bankers to be a rambunctious group, would you? And yet, in the 2012 / 2013 Annual Report that they published last week, they heatedly criticized our political leaders for failing to adapt to the new regulatory realities of the post-Crash banking era.

How heatedly? Well, for instance, the text of the Report asserts that “Continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system.”

Ouch! For a banking regulator, those are fighting words! Clearly, the BIS Directors are peeved that our political leaders haven’t done more to restructure the global banking system.

You may not necessarily agree that our leaders have done too little to implement meaningful reforms. Former United States Representative Ron Paul, for instance, believes that they have done too much to regulate the banking system. In fact, Paul has stated that laws such as the Dodd Frank Act impose “disastrous costs” on Americans.

Whether you side with the BIS or with Ron Paul, though, perhaps you would agree that our banking regulators and our political leaders should coordinate and communicate their strategies more effectively.

The American Economy: Good News and Bad News

Ben Bernanke, the Chairman of the Board of Governors of the Federal Reserve System of the United States, must be feeling a bit frustrated by now.

As soon as he observes a set of consistent signals that the American economy is strengthening, he’ll likely opt to restore interest rates to higher (i.e. relatively normal) historical levels. On the other hand, as soon as he observes a set of consistent indicators that the economy is weakening, he’ll probably opt to move even more aggressively to stimulate the financial markets.

But what will he do if he doesn’t observe any consistent signals at all? In other words, what if he continues to take note of signals that contradict each other?

That’s what happened to Ben last week, when mixed signals about American consumers were released to the financial markets. Good news was embedded in bad tidings, and bad news in good tidings as well.

It’s Good News, Or Is It?

What good news cheered the markets? It was the report that American household debt levels had climbed for the first time since the pre-crash days of early 2008. Although excessive debt is undoubtedly a worrisome situation, many financial pundits interpreted the increase as a sign that consumers are feeling more secure about their jobs and their futures.

On the other hand, some noteworthy concerns were embedded in this good news. Apparently, the increase was largely attributable to surges in student tuition and automobile loans. Although automobile purchases undoubtedly stimulate economic growth, student indebtedness has been “in the news” lately because of its debilitating effect on the work force.

In other words, the news about debt was generally good, and yet one of its underlying causes was cause for worry. That’s the type of “good news, bad news” data that tends to drive federal regulators up a wall.

It’s Bad News, Or Perhaps Not?

Meanwhile, the markets received some unabashedly bad news too. The median annual household income in the United States has fallen to its lowest level since 1995. In other words, a full thirteen years of economic progress in the late 1990s and early 2000s have been fully reversed by the past four years of deep recession and the ensuing tepid recovery.

Furthermore, even though economists claim that the recession of 2008 and 2009 ended some time ago, annual household income has fallen each year for the past four years. Although the national economy has begun to grow again, consumer wealth has continued to slide significantly.

What good news can be gleaned from this depressing statistic? Interestingly, both the Democrats and the Republicans appear to have found a political “talking point” in the data. The Republicans claim that the recent slide in household income can be blamed on President Obama’s economic stewardship. And the Democrats counter that the recession actually began during George W. Bush’s term in office, and that his eight years of service failed to generate any permanent wealth for American consumers.

Quantitative Easing, The Third Generation

These mixed signals have persuaded Ben Bernanke to announce additional actions to stimulate the economy, but to implement them at a scale that is unlikely to trigger massive growth. Skeptics like Nobel Prize economist Paul Krugman have noted that unlike President Teddy Roosevelt, who advocated that the American government should “speak softly but carry a large stick,” Chairman Bernanke appears to be adhering to the reverse strategy.

On the one hand, he has vowed to prioritize economic growth and the employment of American workers as highly as the goal of monetary stability. That’s a major step in a new direction for a government bank that has long focused primarily on maintaining the value of the American currency.

In fact, the Chairman has pledged to maintain low interest rates for the foreseeable future in order to encourage lending and investment activities. And he has expressing his intention to engage in a third round of quantitative easing, a technical term that refers to the injection of federal funds into the financial system through the purchasing of debt securities.

Nevertheless, many pundits have noted that such actions may only affect the American economy to a limited extent. More drastic actions, such as the large scale nationalization of all of America’s global banks, were once debated but are no longer under serious consideration in the United States.

Muddling Through

Although the American equity markets continue to demonstrate significant strength, most economists predict that the United States will continue to muddle through its financial quagmire. With Europe remaining in a banking crisis and Asia troubled with slowing growth and territorial disputes, it is difficult to anticipate any external positive surprises that may jolt the American economy towards renewed prosperity.

Chairman Bernanke might thus be advised to acclimate himself to the current condition of mixed signals. Although “one step forward and one step back” might be a frustrating sequence for any one who wishes to make definitive progress, the American economy appears to be stuck in that very rut for the present and the immediate future.

Big Government to the Rescue!

Finally, this past weekend, Irish Prime Minister Brian Cowen confirmed what foreign government officials, private sector economists, and global investors knew for weeks: namely, that the Irish government would accept a fiscal bail-out from the European Union in order to help it manage its way out of crisis. Ireland thus follows Greece as the latest nation to require such a bail-out; rumors abound that Portugal is the next country in line for consideration.

At a very early stage of the global financial collapse in February 2009, the Irish government proudly proclaimed that it didn’t need significant grants of monetary support from the European Union to help it bring its troubled fiscal situation under control. Instead, it opted to bail out its domestic banks as an independent nation, and it paid for its decision through a combination of massive tax increases and budgetary program reductions. In fact, the Irish were so widely admired by some for their responsible activities that British voters later voted for a new government that promised to follow the Irish model towards economic prosperity.

Regrettably, though, the Irish model has led the Emerald Isle down a path to continual economic decline, as well as outright population loss as working age professionals and laborers emigrate to other nations in search of employment opportunities. These challenges led to escalating bond market pressures on the Irish government, pressures that may finally be relieved, now that the European Union has come to its rescue.

Although naturally oriented towards free markets and against government intervention in the macro-economy, global investors quietly accepted the impending news of this additional massive government bail-out. Interestingly, private investors have begun to accept — and even applaud — similar governmental rescue efforts in the United States as well.

Intervention, American Style

This past week, for instance, the financial markets enthusiastically bought into General Motors’ (GM’s) gigantic Initial Public Offering (IPO) on the New York Stock Exchange. Although GM’s prior shareholders saw their investments decline to zero value during the auto maker’s bankruptcy filing last year, most investment analysts have supported President Obama’s decision to invest directly in the firm’s reorganization and rebirth. Last week’s IPO, which priced the stock at the high end of the range of values predicted by industry pundits shortly before the event, was deemed a rousing success by Wall Street.

Investor reaction was somewhat more mixed in response to U.S. Federal Reserve Bank Chair Ben Bernanke’s vow to stimulate the economy by directly purchasing Treasury securities from the American capital markets, thereby injecting additional liquidity into the hands of the general public. Although some pundits worried that an economy drowning in cash would eventually experience hyper-inflation and a devastating decline in domestic currency values, most accepted Bernanke’s reassurances that there were no signs of an impending spike in inflation. Most also agreed with Bernanke that recent moves by China and other Asian nations to weaken their own currencies were potentially more destabilizing to the global financial system than his own actions.

As if to emphasize the oversight power of America’s national government, representatives of the Federal Reserve Bank also announced plans last week to stress test the nineteen largest financial institutions in the United States. The only other time the Federal Reserve decided to perform such tests was during the heart of the global financial crisis, when investors legitimately feared the imminent collapse of the world banking system. Last week, though, the Fed’s announced intention to monitor the fiscal health of America’s largest banking institutions was perceived by many as a reassuring signal that “big government” oversight functions would remain in place indefinitely to prevent future investment bubbles and economic meltdowns.

The Pendulum Swings

Much was made of the symbolism of the Obama election in 2008. The American people, many thought, had voted to reverse a thirty year trend of free market, anti-government philosophy, and had opted to swing the policy pendulum back towards active government oversight of (and intervention in) the nation’s economic affairs.  Earlier this month, though, the upstart Tea Party voters fueled election victories for the Republican Party; many interpreted these contrary results as a signal that the return of “big government” would halt dead in its tracks.

Despite the Republican Party’s vow to repeal President Obama’s national health care plan, though, individual Republican lawmakers have acknowledged that they lack the votes to actually achieve that goal.  And despite continuing complaints about the economic policies of the current administration, no rival politician has presented a comprehensive plan to overturn (or even modify) the current policies and strategies of President Obama’s economic team.

It thus appears, then, that “big government” politicians and bureaucrats will continue to play major roles in managing the national economies of the United States, the European Union, and other countries around the world for the foreseeable future. Interestingly, perhaps contrary to conventional expectations, the private investment markets appear to be satisfied with that prospect.

Ben Bernanke vs. The Black Swan

Congratulations to Ben Bernanke, the Chairman of the Federal Reserve Bank of the United States, for being named Time’s Person of the Year!

2009 was most certainly a difficult year for the nation in general, and for regulators of the financial markets in particular. Because we began the year on the precipice of what Nobel Prize winning economist Paul Krugman called the Second Great Depression, but then ended it on the threshold of an economic recovery, we heartily agree that this honor is well deserved.

It is somewhat disconcerting, though, that Chairman Bernanke continues to acknowledge that he didn’t anticipate the collapse of our financial and economic systems. That being the case, one cannot help but wonder whether he is responsibly planning for the emergence of the next black swan.

They’re Not All White

Huh? A black swan? Aren’t all swans white?

In reality, black swans do exist, and they played a prominent role in Nassim Nicholas Taleb’s 2007 best selling book The Black Swan: The Impact of the Highly Improbable. That’s because, for many economists and financial strategists, black swans are quintessential examples of faulty presumptions of impossibility.

Okay … so what do we mean by faulty presumptions of impossibility? Well, for centuries, Europeans assumed that all swans are white because the only swans they ever saw were white. But some free thinkers warned that, although highly improbable, it might nevertheless be possible for black swans to exist in some remote corner of the world. And lo and behold, one famous day in 1697, Dutch explorer Willem de Vlamingh discovered a pair of black swans in the New Holland region of coastal Australia.

Ever since then, the black swan has assumed an important meaning in the minds of financial market strategists. Namely, they represent events that have never previously happened, and thus are often falsely assumed to be incapable of happening … until they actually do happen. The simultaneous collapse of all global markets and economies last year, for instance, represented one such black swan event.

Some Say Black, Some Say White

Or was it truly a black swan occurrence? Bernanke would have us believe so; he has repeatedly described the great bank bailout of 2008 as an extraordinarily rare event, one not required since the bank failures that followed the great Wall Street stock market crash of 1929.

One problem with Bernanke’s assertion, though, is that such collapses actually tend to occur distressingly often. After all, the Dow Jones Industrial Average did decline by over 45% between 1973 and 1974; it later declined by over 22% on a single “Black Monday” day in October 1987. It subsequently declined by approximately 27% between 2001 and 2002; considering the frequency of these declines, one might expect such crashes to come along once every decade or so!

In fact, in his 1954 classic The Great Crash of 1929, Harvard University economist John Kenneth Galbraith noted that “the memory of the financial mind lasts about ten years.” Galbraith explained that, in his opinion, it takes ten years for the painful memories of each market crash to fade away in the minds of investors; thus, every decade or so, they can be expected to become irrationally exuberant and to begin to assume reckless levels of risk. In other words, Galbraith believed that we are doomed to experience crashes relatively frequently because human nature leads us to forget our hard-learned lessons during such time spans.

Furthermore, recent developments in the financial markets, in technology, and in society have facilitated the rapid spread of global market panics. The emergence of our 24/7 internet based news media, for instance, has made it possible for terrifying rumors and distressing news to spread across the globe in the blink of an eye.

And the use of computerized trading systems has made it possible for hundreds of billions of dollars to be yanked out of entire industries, nations, and global regions in a matter of minutes. According to Galbraith, then, global market collapses should not necessarily be interpreted as once-in-a-lifetime black swan events; instead, they should be expected to occur as regularly as the American decennial census.

He Still Deserves It!

So do we believe that Chairman Bernanke doesn’t deserve the Person of the Year award? We certainly wouldn’t go that far; in fact, even if one believes that Chairman Bernanke should have been better prepared to anticipate and respond to the collapse of our financial markets, one cannot help but admire the manner in which he ignored our political maelstrom and plowed ahead with his plan to flood our economy with liquidity.

Nevertheless, true economic prosperity will only arrive when investors regain confidence that Bernanke is prepared to manage any unanticipated problems that may occur in the future. Whether these problems are truly black swans, or whether they are foreseeable and are thus amenable to principles of enterprise risk management, our Person of the Year must nevertheless be prepared to manage another challenging year in 2010.