Just a few quick thoughts here as the policy situation remains extremely fluid as the crisis evolves.
- Deflation is still the more likely outcome. I described earlier in the year that there is a strong likelihood of deflation versus inflation. The housing bubble and subsequent bust is the largest single credit collapse that the world has ever seen. This will put tremendous downward pressure on banks and the money supply as loans are repaid, defaulted on and not renewed. Make no mistake, it will take a colossal policy effort to overcome this crashing wave of trillions of dollars in public debt.
- Hyperinflation is a very low risk. Many market participants are concerned about the potential for hyperinflation as Central Banks and Treasuries pour money into their various economies. I think this risk is overblown. From my perch it appears that much of this thinking is based on a rather simple misunderstanding – the idea that Central Banks will expand their balance sheets via Quantitative Easing (commonly referred to as QE) which will flood the banking system with reserves thereby leading a multiplier effect. This, however, is based on a misunderstanding of modern banking as banks are not reserve constrained. Further, I think the demand for money is likely to increase as the credit crisis will increase the demand for safe assets. Much of this confusion appears to stem from confusion over the way Monetarists and Ben Bernanke think about banking and the Central Bank’s control over lending.
That’s all for today. I’ll have more in the coming days. Stay safe out there.