Sunday, October 29, 2006

Bickering Central Bankers

The Fed does not believe excess liquidity is the source of asset bubbles. (See my previous post describing the Fed's attempts to prove this.)

On the other hand, at least one European central banker seems to be talking otherwise. See this quote from Prudent Bear quoting Otmar Issing's statement published at Market News International:

' “Central banks are now realizing they must take global levels of liquidity seriously, the ECB’s former chief economist, Otmar Issing, said Friday. ‘I am concerned about excessive liquidity in the world,’ Issing told a conference for economic students here. This concern is shared by the current members of the ECB’s Governing Council, who have taken the lead in alerting other central banks to the risks at hand, Issing noted. ‘There is now increasing support of the view that excessive liquidity world-wide is fueling asset prices and is something which has to be taken seriously by central banks…This is a real concern.’” This afternoon from Market News International.'

[Thanks to for the image.]

How can two such illustrious and learned groups be at such odds? That alone is enough to prove to me that econometrics is still a misused tool and economics is still in its infancy as a science.


Blogger Idaho_Spud said...


They all seem to be pushing the string. They raise short term rates, while trying to alleviate the effects of those rate hikes by putting more money into circulation. Of *course* it's inflationary!

Here's the quesion for you though. I've been following the inflation-deflation argument for a while now... We have several systemic imbalances in place right now: Massive deficits that will require inflating. A nasty deflationary housing-led recession in progress. A savings-bereft middle class. Lack of savings may lead to deflation in other areas of the economy (no money to buy stuff). Yet the government has obligations to pay.

Can you foresee a point where the government inflate while the economy deflates, like Japan?

Given that (unlike Japan) ours is the world's reserve currency, and that the world's economy is presently tied to the fortunes of America's middle class, what do you see as a safe place to preserve capital?

6:17 AM  
Blogger Katy said...

Idaho Spud,

Thanks for the comment.

Let me first clarify that I am not a crystal ball reader. I have no secret information or knowledge.

I'll also note in passing that massive deficits may not require inflating, as long as the world is willing to finance them with or without it. If you disagree, please let me have your thoughts.

On to your main question. I agree that the Fed is now between a rock and a hard place (see some of my previous posts) as concerns their objectives. On the one hand, they are supposed to be able to control the health of the economy and employment, and on the other they have responsibility for the health of the dollar and its retention of status as the world's reserve currency.

I believe -- note the word believe, i.e. I have no scientific proof of this and it is just for the sake of discussion, something I love to do but which I do not pretend is more than pushing hot air around between you and me -- I believe that the government will choose to allow more than the usual inflating rather than try to squash it, because they fear allowing the economy to slide.

I also believe that this choice will in turn push the dollar lower, at least for the moment. BUT -- remember, all the other nations of the world will take this as a signal to follow suit. As they race the dollar down, relativity will seem to prop up the dollar's foreign exchange value. SO...

If all the world currencies are following each other slowly down the drain, what is the only thing that can move in the opposite direction? Assets. I mean gold, commodities, hard assets, and I suppose eventually everything else when they get around to it, even the stock market and prices in general.

Gold has already reacted to their actions by creeping upwards over the last few years. (You can take gold out of the standard, but you can't take the standard out of gold.) Commodities and real estate followed and are already high. If the Fed policy continues as I say, these categories may simply retain their dollar gains instead of crashing as feared. And as for real estate, this would please the Fed enormously, because it will make it seem to the world that the "soft landing" has materialized as they predicted.

I also believe this chronic Fed tolerance of slightly higher inflation could lead to -- or prolong, because I think we're already in the early stages -- the stagflation you refer to (inflating while the economy deflates, or at least as it slows down.)

For the situation to become acute, the market would have to react negatively, and thank goodness the market is savvy. It is used to these events (dare I say shenanigans?) by now. The only thing that could throw a curve ball is unpredictable statistics. I can't say whether the CPI will rise or not in the above scenario, and both the marketplace and the Fed are watching them like a hawk.

So as I said, a mild sort of stagflation may be upon us; but I don't think it will last too long this time, because its perpetuation would mean prices will be increasingly on the rise, and the Fed is not supposed to stand for that. We expect the Fed to act against that.

So, if prices rise significantly, or for a significant period of time, the Fed will eventually be forced to raise rates; but they will fear that if they do, the economy will tank for sure. This fear will place them even further up the creek than they are now. If they were to lower rates, iinflation would skyrocket. I wouldn't want to be in the Fed seat over the next few months.

I think gold will go up until this situation is resolved one way or another. If the Fed lowers rates or continues to inflate behind the scenes, gold will climb inexorably. If the Fed throws in the towel and starts to raise rates, look for gold to peak and stabilize. Then, and only then, do I believe I'll want to get back to the ordinary business of saving and investing as usual.

But what do I know? You'd be a fool to listen to a silly blogger for your investment advice. I do this to engage readers like yourself, to inspire people to learn about economics and investing so they can think for themselves, and hopefully to stimulate them to watch out for government intervention in the marketplace and to look for ways to preserve the value of their hard work and accumulated assets.

3:15 PM  
Blogger Idaho_Spud said...


Thanks for the well-thought-out answer and post. Your scenarios make a great deal of sense. Your scenarios forced me to re-visit memories of the mid to late 1970s. Got any old WIN buttons stashed away? :)

I'm of the opinion that we have already entered a recession - one that will turn out to be quite a nasty one. The punch bowl runneth over for too long this go-around, I'm afraid, and the hangover is going to be a nasty one.

Just to be clear, I'm not asking advice, just your opinion ;) I've been in capital preservation mode for a couple of months now, trying to decide how deep a cave I need to find, hahaha.

I'm subscribed to your blog - you rock! Thanks for taking the time to share.

6:57 AM  

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