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There is a simple paper out of the St Louis Fed discussing the current impotency of monetary policy in the current environment.  In essence, it describes what I have been harping on forever now – that monetary policy is ineffective in times of a balance sheet recession because there is no demand for debt.  The piece is appropriately titled: “”You can lead a horse to water”.   This piece discusses the current size of the Fed balance sheet and the risk of inflation:

“Many economists worry that bank lending and monetary growth will eventually surge and, ultimately, cause higher inflation.”

But the problem here is that there is an important step in the process missing.  These “economists” seem to believe that the USA will morph from some sort of deflation/disinflation into inflation overnight.  But the process here is important to understand.  In order for inflation to make a meaningful negative impact you must FIRST get a recovery.  In other words, the private sector balance sheet must heal to the point where they want to take on more debt.  This is how a recovery from the current crisis will manifest itself.  This is part of what makes the whole inflation argument so ludicrous (and explains rather succinctly why they have all been so fantastically wrong).  Ben Bernanke would absolutely love to see 4-5% inflation right now.  That would mean we have a pretty good problem on our hands – our economy is red hot.  It is on fire.  Loan growth is steaming because the housing market is back, banks are lending, companies are leveraging up their operations, etc.  That’s the problem China has been having for the last 10 years and they’re the envy of the modern economic world.

In summary, let’s not skip steps in the process here.  Inflation will likely occur during a recovery.  And by then all of this chatter of default and USD collapse will be long gone.  It might get the hyperinflationists hyperventilating again, but these same people fail to understand what hyperinflation actually is – it is the death of the currency that generally occurs due to a lack of faith in that currency.  And that my friends will not occur if we experience a booming recovery and a surge in loan growth.  The two simply do not go hand in hand.  But this is all assuming we get the whole “booming economy” part which, in my opinion, is highly improbable.  Thus, prepare for continued disinflation with a risk of full blown deflation….


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