The Sky Is Falling But It Is Still ‘Credibility Shredibility’

The villagers of indomitable Gauls had superhuman powers thanks to the magic potion brewed by their druid, Getafix. Those Gauls were supremely confident in resisting the mighty Roman Empire and repeatedly trouncing its powerful armies. Their biggest fear was that the sky will fall on their heads.

The country of USA also has ‘super-economic’ powers. Her magic potion – brewed by her druid, the US Treasury – is US Dollar, the reserve currency of the world and her military supremacy. But, unlike Asterix and Obelix of the village of Gaul, the Federal Reserve Bank and the US Congress are not afraid of the sky falling on their head. They don’t even notice it.

Never mind the anemic jobs growth or the persistent depression like economy. Never mind that nearly 13 million Americans are unemployed. Never mind that over 42% of unemployed have remained so for an extended period. Never mind over 8 million involuntary part-time workers, who would rather have a full time job. Never mind the national under-employment rate of nearly 18%. Never mind the jittery stock market eroding the wealth of a generation. Never mind the threat to the global growth due to significant impact of the mighty American economy in trouble.

The Federal Reserve Bank and the US Congress still do not seem to believe that we are in a deep doo doo. The decade after the 1929 crash was pretty bad for the developed world – mostly America and Europe. Though there is much dissimilarity between problems then and now, the sharp rise and extended plateau of high unemployment rate are somewhat similar – not in terms of magnitude but in terms of the time elapsed. (See graphs: 1930s, 2012)

The prolonged bleak employment picture is keeping a lid on the US stock market. The situation is not good for the global stock market too, mainly due to problems in the developed world, including the United States.

The financial crisis in Europe is still blazing. The growth in emerging markets is significantly slowing – a victim of the European crisis. United States is the ‘cleanest dirty shirt’ in the laundry room of the world economy. When her shirt starts to get dirtier – like now – then if that is not like the ‘sky is falling’ then it is quite close.

However, neither the Federal Reserve nor the US Congress is fazed. It is still business as usual – full steam ahead to the set course – for them.

The gridlock in the US Congress is amazing. The Republicans, who control the House of Representatives through majority and the Senate through filibuster, are more determined to defeat President Obama in the upcoming election than to do anything to improve the economy. They are happy with a do nothing Congress label, which is perceived to be shared by the Democrats, then to create growth and economic prosperity, which could be perceived as Obama’s doing.

The Obama Administration is too timid to propose any big, bold idea to restore growth and jobs lest it upsets the ‘Very Serious People’ – the so called centrists. The popular wisdom – at least for Democrats – is that one needs to court the center to win the election, if that disappoints one’s base or compromises the guiding philosophy then so be it.

The Federal Reserve is too pre-occupied with battling future inflation – which may or may not come in the near future – and not so much with growth in the present. The monetary policy objective of the Federal Reserve as stipulated by the Congress is:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

These objectives are laid out very ‘subjectively’ and the Fed deliberately maintained ambiguity about their acceptable levels, i.e. until early this year. In January ’12, in an apparent victory for Chairman Bernanke, Fed set the inflation target of 2 percent, stating that it is best aligned with congressionally mandated goals of price stability and full employment.

This was a historic shift, but in my opinion, the historic part of the announcement was:

However, it [Fed] said it was not appropriate to adopt a fixed goal for employment because the level of unemployment that can be achieved without sparking inflation is not largely determined by monetary factors.

Basically, what Fed telegraphed to the world is that the goal of full employment is a ‘second class citizen’, and depends entirely upon the objective of price stability. It set an upper ceiling for inflation but not a lower limit nor did it set a target for deflation. Neither is there any target for acceptable level of unemployment. From this, if one gets the idea that in case of rising inflation and very high unemployment Fed will tackle inflation and leave the unemployment situation to the vagaries of economy then one could be forgiven.

But perhaps, that too is not enough for some Fed members, who are warning about the inflation risks (here and here). Even, ‘helicopter Ben’, like his counterparts in ECB and elsewhere, is more concerned about defending Fed’s inflation fighting credibility then to do something like what he proposed for Japan:

We have, uh, we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable, in that we’ve been able to take strong accommodative actions in the last four or five years to support the economy without leading to a, [indiscernible] expectations or destabilization of inflation.

Professor Paul Krugman says that Fed has too much credibility:

May I say that what recent events in Europe, and to some extent in the US, really suggest is that central banks have too much credibility? Or more accurately, their credibility as inflation-haters is very clear, while their willingness to tolerate even as much inflation as they say they want, let alone take some risks with inflation to rescue the real economy, is very much in doubt.

So what is happening around the world? It seems that deflation is somewhat more of a threat for the world then inflation in general and more so in developed economies.

In China, which essentially is world’s growth engine at the moment, broader measures have slumped to stagnation levels not seen since the late 1990s.

“China is in deflation,” says Charles Dumas from Lombard Street Research. Yes, consumer price inflation is 3.4pc – though falling – but consumption is a third of GDP. Fixed investment is 46pc, and here prices have dropped 3.5pc in six months. Export prices have dropped 6.6pc.

The USA Today reports that a growing number of economists and managers are worried about impending deflation then inflation.

Economist A. Gary Shilling argues that many of the factors for deflation are already in place, and that people overlook falling prices because they are so focused on the items they use the most.

Elliott Wave theorist, Robert Prechter contends that the biggest risk to the economy is deflation so does Jeffery Kennedy of Prechter’s Elliott Wave International, indirectly, by applying the Elliott Wave Theory on CRB Index to make a case for a short trade.. The sudden collapse of CRB Index does give credence to this hypothesis.

So there we have it. A mighty economic and financial problem facing world and the policy and political leaders are still dithering – whether to take Keynesian or austerity approach, whether to worry about future inflation or current lack of growth problems. In the meanwhile the Rome Burns – oh well, in contemporary world it is the Italian-German 10-yr bond spreads, which are burning or reaching record high, if you please.

Finally, quoting commentator Ambrose Evans-Pritchard of The Telegraph,

The problem is not scientific. A world slump is preventable if leaders act with enough panache. The hindrance is that the Euro Tower still haunted by Hayekians, and most G10 citizens – and Telegraph readers from my painful experience – view such notions as Weimar debauchery, or plain Devil worship. Economists cannot command a democratic consent for monetary stimulus any more easily today than in 1932.

One can only pray that helicopter drops do not become necessary in the chilly winter of 2012-2013.

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