How Can We Not Call This Inflation?

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Inflation is a funny concept right from the start. You can ask pretty much anyone what inflation is or where it comes from and the answers usually begin, and end, with the CPI. Even the Federal Reserve, a policymaking body that has a great deal to do with that, no longer uses the CPI, changing instead in 2000 to the PCE deflator. Consumer prices are believed to be the full extent of inflation without ever questioning whether that is a means or an end. To monetary policy, it is both.

The methodology of QE is inflation in this manner, subjugated by the very real constraints of the very real world. It is simply accepted that the Fed can and does "print money" which causes inflation, more money chasing fewer goods and such, but complications arise from even that. If the Fed prints more money and gives it exclusively to banks, why would we expect that consumer prices would rise? Just from an accounting perspective, banks are engaged in all manner of financial activities so it would seem at least reasonable that banks might use that largesse in furthering purely financial aims.

To a great extent, that has actually happened; and I am not meaning exclusively asset prices. While it has taken a few years, it has finally dawned on those that examine such things that financial liquidity as a system has probably never been worse. Even in markets taken as the highest order of pure finance have found themselves "victims" of irregularity (curiously enough, often in the form of repetition and regularity) exclusively associated with illiquid function. We can "thank" QE for that.

Wholesale money markets used to be robust places, if only on presumptions that turned out to be nightmares. Dealer banks were the bedrock of that, for various reasons that I have discussed to no end. They are largely gone, and small wonder since QE has replaced any and all need for them to fund dealer activities, both as a matter of their asset and liabilities sides. In very simple terms, after 2008, the Fed used QE to essentially replace the dealers in global short-term finance because the dealers had already exited the business; thus QE means they don't have to come back and really have no profit motive to do so now.

But if that is really the case, and it is, then QE and consumer inflation are already clouded. If QE's creation of "reserves" went almost solely to replace the existing network of wholesale money dealing, traded liabilities, that doesn't leave much to find its way into the real economy, and thus the CPI or PCE deflator. That would mean the trick of QE and inflation, as it always was, was never in money printing or even actual money but rather in hopes and expectations that it might if all the financial conditions converged under just the right circumstances.

That was one reason it "had" to be large, as those portioning it were aware of these very real financial limitations, though it is clear they have underestimated them. If, like a bathtub, QE's effects are to fill up the financial basin first there has to be enough of it to spill over into where it is intended. Therefore we have more money chasing not only goods but replacing past financial activities first and foremost.

If QE was so tied up in the tangled mess of the panic aftermath, then that raises the question as to why the US did not suffer the same fate as Europe, particularly in 2012 (I would argue, however, that we did just not to the same degree - yet). Even Paul Krugman, who has been consistent in his criticism of QE criticism of runaway inflation, believes the US got the better bargain on central bank strategy. Writing last September :

"And there but for the grace of Bernanke go we. Things in the United States are far from O.K., but we seem (at least for now) to have steered clear of the kind of trap facing Europe. Why? One answer is that the Federal Reserve started doing the right thing years ago, buying trillions of dollars' worth of bonds in order to avoid the situation its European counterpart now faces."

Not to be outdone, and more broadly aimed, Ambrose Evans-Pritchard writing in The Telegraph, closer to the QE source all the way back in December 2013, was effusive in his praise even if, toward the end, he grew closer to naked reality :

"As the US Federal Reserve starts to drain dollar liquidity from the global system at long last, let us celebrate success. Quantitative easing has worked marvellously [SIC] well. Monetary policy has been vindicated.

"The US, UK and Japan are all recovering, moving closer to "escape velocity". The Swiss National Bank - that bastion of orthodoxy - has kept its economy on an even keel by quietly amassing a bond portfolio equal to 85pc of GDP."

Only the UK might (stress might) be left standing out of that checklist of purely assumed success: Japan has been through recession since and has given no sign of moving out; the Swiss famously and "unexpectedly" abandoned their bastion because of the "dollar" not the euro and taken a huge amount of financial beating for doing so; while the US is, if not in recession already, making one hell of a run at one. Retail sales for all of 2015 so far are among the worst in the entire series, factory orders have seriously shrunk, exports continue to decline (blamed on the dollar) while imports do as well (so much for that dollar explanation), and on and on.

There seems to be a practical divorce here between what everybody seems to believe QE did and the hole left behind from what it did not. Start with the difference between the US and Europe, a matter that really and truly is not difficult to understand. It's easy to, perhaps, give Ben Bernanke the benefit of the doubt about it but far less fanciful in terms of the bond market. The huge chasm between the US recovery and that in Europe, apart from the strangle of the euro, is due to Europe's dependence on banking solely; was QE3 in 2012 all that different than the LTRO's of earlier in 2012? No.

Unlike Europe, or Japan for that matter, the US still conceives a robust private bond market to which even banks themselves participate. So as the clog of global banking under the eurodollar standard removed bank balance sheets from financially "benefiting" the global recovery, the US bond market was there to pick up at least some of that slack almost immediately. As early as the spring of 2009, corporations were floating any number of billions in bond issues, all the while the banking system was still figuring out if there would be anything left of its prior follies. According to SIFMA, US corporations of all varieties issued $754 billion in corporate debt in 2009, which was $90 billion more than 2008, and would have been a record if not for the huge surges in 2006 and 2007.

The numbers in the years since are simply staggering. In just the past three years, there have been $4.2 trillion in corporate bond issues. That compares to $4.5 trillion in the five years from 2003-07, and $4.0 trillion in the seven years 1996-02. In terms of junk and high risk, the numbers are even further skewed: $975 billion in the last three years; just $648 billion in the five years from 2003-07; and, only $550 billion in the seven years 1996-02.

Despite not being directly tied to banking and the Fed, QE is given credit for that too. Even if you accept that premise, the means for doing so are not exactly direct. Here we venture more so into the realm of pure monetary theory and less about the direct matter of dollars and cents. The drive into this "reach for yield" starts with QE's impression upon interest rates. In fact, when typically listing QE's accomplishments, they typically end not in the Hollywood-style glorious sendoff into the sunset of an actual and widespread recovery, but mostly in relation to lower interest rates. So the Fed supposedly reduced interest rates and the corporate bond market blew out as a result, full stop.

As I mentioned toward the beginning, the Fed has been quite constrained, and quite vocal about this constraint, since December 2008 - the zero lower bound (ZLB). This mythical barrier has perplexed monetary theory for years, decades really, even and especially as the Japanese went there first. Because finance used to be about actual money there really isn't much of a negative interest rate possibility, especially when concerned about time value. Once the Fed "got" the federal funds rate down to zero (and even that isn't direct, but I won't go into that again here) where to go from there?

That brings us back to inflation once again, because to overcome the ZLB monetary theory poses real interest rates as the primary setting for real economic outcomes. Since real interest rates are defined as nominal rates minus inflation, consumer prices exclusively, the Fed's job left money far behind and moved into psychology exclusively. In other words, QE's entire idea was to get everyone to believe that it could create inflation, and thus those inflation "expectations" were enough to create and maintain negative real rates. But, as noted above, in order for that to work everyone had to ignore the very real problem of QE and the Fed being at least one step removed from actual credit flow.

Janet Yellen and others have suggested that should never be a problem solely as a matter of "markets" never looking behind the curtain - just accept what you are told and leave the hard matters to the experts as there aren't any, apparently, in markets. In many ways, that fairy tale framework has actually become the overriding guiding force in monetary theory, as hard as that may be to accept. Even Paul Krugman would be forced to admit as much especially when taking into account the all-too-necessary corollary to QE, "forward guidance."

This is a topic in which he has close familiarity, having chastised the Bank of Japan going back to the 1990's on just this sort of fairyland monetarism. Apparently, QE can only work when everyone accepts that it doesn't work. Or, to turn it around, QE cannot work if everyone thinks it does. Welcome to forward guidance.

Earlier this year, in lamenting the sudden break of the Swiss National Bank out of its suicidal "dollar" position, Krugman described BoJ's task as needing to "credibly promise to be irresponsible" - what matters for central banks and monetary policy in fiat is not money but credibility. The reason for that is rational expectations and the forced equilibrium that causes all manner of crazy interpretations. Rational expectations essentially means that all market prices are market clearing, and thus fully and completely efficient. If that is the case, and monetary theory accepts it without fail, then how can QE ever get lower interest rates, or even any inflation at all?

If bond investors feel QE will be successful, then they will demand today, not tomorrow, a lower bond price and thus a higher, not lower, yield. If you accept the idea that QE is powerful and does work in the manner described and proclaimed, ignoring the inordinate complexity and mess in the finance end of it, you have every reason to sell bonds, all bonds, the moment it is announced. Its success would mean higher inflation and a better economy, both of which history suggests occur at greater interest rates which makes bond buying a really poor investment choice. If markets are purely rational, QE dies in the womb because everyone believes it works.

Forward guidance was invented to overcome rationality (fantasy is hard). In Krugman's scenario for Japan, the central bank had to convince markets that it would be "irresponsible" for long enough to surpass a financial line-of-sight of sorts; to get QE's termination beyond the expectations horizon, that QE or whatever monetarism could be dreamed up would be in place long enough that bond investors, in particular, would not be concerned about its end. If that occurred, then, and only then, it is believed that a central bank could get around the "rational" impulse of investors to sell bonds the moment QE arrives and embrace its active buying of them.

In the US, that was why, in QE3 in particular, Ben Bernanke tied it to the unemployment rate as there is another "rational" problem. In overcoming the bond investors' rationality, QE then endangers expectations in the real economy. In other words, if a central bank promises QE will go on and on, secretly only in light of bond investor expectations, then there is also the danger that real economy expectations begin to view it as weak and powerless or that economic circumstances are so dire as to take an inordinate amount of time to reverse back to health. Either would undermine the very inflation expectations that QE seeks to court.

By grasping the unemployment rate, Bernanke's task was essentially to thread a needle of assuring the bond market QE didn't work too well while simultaneously assuring real economic agents that it did.

None of this has much to do with money or even credit, apart from what is aimed to be manipulated. Monetary policy used to mean literally money, or at the very least actual currency. When Milton Friedman changed monetarism in the early 1960's by refashioning the Great Depression into a monetary issue, it wasn't inflation expectations or the accumulate mass feelings of investors in question, there was, in his view which is arguable if still commonly accepted, a real issue of money supply. Banks needed actual physical currency regardless of any other factor. Friedman's preferred solution, one he referred to time and again, was actually the suspension of convertibility which would have had the effect of ending the bank runs by making physical currency legally unattainable by the public (at least until order could be restored, assuming, of course, that was realistic). Today, that would be taken as heresy because of how that might impair positive feelings.

Milton Friedman believed central banks should actually and physically print money (currency) while Ben Bernanke tasked himself with confusing as many people as he could about how that might work - and showing, over the last years of his tenure, that his grasp of the subject may not have been quite so solid either.

If it all ended there it would itself still be quite some story, one that sadly very few seem to appreciate in its full bloom. There are very real effects to all this, whether QE-based or not, starting with junk bonds and even leveraged loans. The staggering tally of low-rated debt being floated in the past three years, tracing to at least the timing of QE3 and the whispers preceding it, are almost unthinkable. Subprime mortgages came to be known as "toxic waste" for some very good reasons, so much so that at one point all structure financial products, even those having nothing to do with subprime, came to be regarded as the same. Risks were not well understood and that meant a sweeping judgment on the class rather than individual assessments of the products.

Estimates vary somewhat, but it is commonly accepted that subprime totaled about $1.3 trillion by March 2007. It almost seems quaint now where trillion is an everyday occurrence, but that was and remains an immense imbalance. Worse, almost all of it was piled in at the end, something that traces at least directly to Alan Greenspan. According to the San Francisco Fed, the proportion of subprime was about 4% in early 2003, having ticked up slightly from 2.5% when Greenspan started "reducing" interest rates in and after the dot-com recession. He got to 1% in June 2003, and right around that time subprime jumped to 10% of all mortgages - expanding not just in terms of subprime share but also a share of a market that was overall growing rapidly. The San Francisco Fed tries to attribute some of that to its data source, saying that reflects an increase in coverage in the MBA series, before admitting that it was a very real surge.

Subprime peaked in the second half of 2007, almost a year after housing irregularities began, at 14% of total residential mortgages!

The corporate bond version of that, junk debt, is far greater now. In addition to the nearly $1 trillion in junk bonds floated (gross) just in the past three years, there has been, according to S&P/Capital IQ, also $1.6 trillion in leveraged loans packaged in that same timeframe. Leveraged loans are syndicated debt of low-rated, non-investment grade corporate obligors that have trouble finding credit elsewhere; the bank-driven twin of junk bonds. For all that debt and the bond market, there is very little of consumer inflation in the official calculations.

One reason for that is the nature of the debt itself - these are not loans and bonds that are funding new expansions, putting more "money" in the hands of workers, all this is financing sclerosis. In other words, companies that are having trouble maintaining cash flow through actual profits are avoiding that reckoning by the ease at which they can participate in this debasement. New debt only replaces lost organic cash flow; that isn't going to be "more money chasing fewer goods" but rather the same dead end as QE in internal banking liquidity. Worse still, for QE theory, even investment grade debt is flowing more so, by extreme amounts now, to stock repurchases than actual economic investment.

This has gotten so far out of hand that even Janet Yellen has taken to publicly stating concern, a clear "no-no" in terms of forward guidance. From her perspective, bubbles are now simply part of the landscape and that they aren't really concerning except if irrationality is "allowed" to enter; meaning that such irrationality, should it affect asset prices, becomes rational (I wish I were making this up). And so even here QE performs psychological guidance as a means of dispelling concerns that it doesn't want; in this case, QE is taken as a tool that obliterates "tail risk." But in order for that belief to work, QE has to be viewed as having been very positive for systemic liquidity, which it clearly wasn't with its idle, narrow and largely useless reserves that have actually obliterated not tail risks but systemic liquidity itself. So for bubbles to continue to be "rational" Ben Bernanke, and now Janet Yellen, had to place asset prices as rational but only on the basis they remain ignorant.

Inflation isn't really consumer prices, as those are a symptom of the true debasing element - changing the standards and benchmarks. Inflation, properly defined, is reducing the standards for trade, in this case currency or monetary value. There is no money anymore, so we can't even define what the standard that might be devalued actually is. Monetary theorists can't even describe, in common language, what QE is and how it works, which is why everything they proclaim always boils down to some version of "trust me." It was not all that long ago that such massive increases in debt were taken as a sign of immense economic and financial weakness and asset bubbles used to be described as immense dangers; now they are all tools to be wielded by the same people who have so debased monetary policy as a concept that it contains no money but an indecipherable mess of contradictory intentions and factors.

True money and an actual strong dollar would have none of this, most of all because they are all extraneous agglomerations of nothing but an exchange of power. Money itself has been debased, not in price because there is no price anymore just as there is no real definition of a "dollar." The introduction of fiat started the movement, ironically during the Great Inflation, but it has taken even newer meaning in the shift in the eurodollar standard around 1995. Krugman, Bernanke and everyone else are looking for inflation and not seeing it because it is so much larger than the CPI or PCE deflator. The entire governing dynamics of finance and economy have been abused and expanded (and reduced) so much that what used to define value just a generation ago no longer applies to anything - this includes comfort with debt above all else and especially asset bubbles.

Some will strenuously object, but this is the very definition of inflation. The standards and benchmarks have all been rearranged with only one object in mind, to allow the top-down structure to not just dominate but do so to the total exclusion of all else. Those that protest call all this progress, to which the rest of the world asks, "where is it?" We have an enormous corporate risk and debt bubble at the same time as no recovery and a global economy close to, if not already in, recession. Monetary theory wholeheartedly and enthusiastically embraces the former to all exclusion about the latter. How is that not debasement?


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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