Inflation Targeting Perils

Inflation or deflation
Tell me if you can
Will we become Zimbabwe
Or will we be Japan?

– Merle Hazard

Ol’ Merle Hazard has the key question figured out. Which will it be? Zimbabwe or Japan? Will it be runaway inflation…or deflation that refuses to run anywhere?

Long suffering Daily Reckoning readers already have our answer. We gave it even before the bubble burst in ’07/’08.

“Yes!” we said…it will be Zimbabwe AND Japan. But not in that order. Japan first. Then, after the feds have got the hang of Quantitative Easing, it’s Zimbabwe here we come!

But there’s gotta be a surprise, right? It can’t be that simple, can it?

Markets rarely make it easy for you. And for a very good reason. If it were easy to see what was coming, it would be easy to avoid trouble and take advantage of opportunities. You can see where that would lead.

Investors would race ahead and ruin the whole thing. If they saw the market going up, they’d buy stocks. This would cause prices to rise before they were supposed to. And if they were going to crash, investors would sell off their stocks…and drive prices so low, the market couldn’t crash – it would already be at bottom.

Do you see where we’re going with this? If investors – or anyone – could see what was coming, they’d short-circuit the process.

Take the run-up in stocks on Wall Street today, for example. On Friday the Dow fell 62 points. If you knew it was going to fall for the next 2 months, you’d sell now? Why wait?

And look at gold. It hit $931 on Friday. If investors knew it would be at $1,000 by the end of the year, it’d be at $1,000 now.

If people could read next year’s fashion magazines, they’d buy tomorrow’s fashions today. Then, some wiseacre would buy the day after tomorrow’s fashions…just to be ahead of everyone else. And then, nobody would want to be stuck with tomorrow’s hairdo – it would already be out-of-style. And nobody would want to hold the stocks that were supposed to go up either. Other investors would have already bought them…and be on to the next thing. The stocks that were supposed to go up tomorrow would go down. Tarnation! All of history would move forward…faster and faster…as people tried to race ahead of trends before they even began…and in a flash…history would come to a blinding stop. We’d all anticipate everything that was going to happen. Why bother reading this book, we’d say to ourselves; we know how it will turn out.

Imagine what would have become of Napoleon’s march on Moscow. “Nah…count us out,” his troops would have said. And what about Tojo’s attack on Pearl Harbor? How did that turn out? “I think I’ll go into the auto business instead,” he might have said to himself. And what about all those homeowners who were speculating on higher house prices? Forget it…the whole bubble never would have happened…and so the whole credit crunch never would have happened either. And then where would we be?

A New York Times financial reporter revealed how easy it was to fall into the housing debt pit in a confessional piece in this weekend’s International Herald Tribune. Here was a smart fellow… His beat was covering the international monetary system and the central banks. He knew all about the credit bubble – he reported it to NYT readers.

But while he was reporting on the world’s bubble economy, his own finances bubbled up on him. A second marriage…a second house…pretty soon he had a mortgage that he couldn’t pay – and that was before the bottom fell out. Now, he’s months overdue in his payments and calls the mortgage company to see when they’re going to kick him out. “Take a number,” they say. “We’ve got hundreds of people to process.” He’s still waiting.

Even when you think you know what is going on…you can be blindsided. The NYT reporter says he got into his mess with his “eyes wide open.”

Alas, that’s the way it works. Even when you have your eyes open and your thinkin’ cap on…still, things happen that you didn’t expect.

“Gap between Boomers, young minorities grows,” says a headline in USA Today. The report tells us that the Hispanic population is growing 16 times faster than the population of non-Hispanic whites.

Not only does this gradually change the racial makeup of United States of America, it also highlights another gap: the old white people have the money.

For that insight we thank the International Herald Tribune. Older people typically had already paid off their mortgages, so were less often caught up in the sub-prime crisis. The over-65 crowd reports only a quarter of the problems paying rent or mortgages as those 18-29. They also tell surveyors half as often that they’re having trouble paying their bills. And get this; while the 18-29 crowd has lost millions of jobs during the last 18 months, employment among 65 and older Americans has actually gone up.

Older people also report fewer investment losses. Their investments were relatively safer than those of younger people…and less affected – though still hit hard – by the downturn.

But thank god for all the Hispanics. The feds are running up trillions in debts – much of which will be passed on to the next generation. At least the Hispanics are filling out the population – bringing millions of new debt slaves into the Land of the Free, so that old, white people can continue to live beyond their means.

But wait a minute…aren’t these same babies the ones who expect to receive free day care, welfare, unemployment compensation, free public schooling, food stamps, health care, government jobs and all the other benefits of a bread-and-circuses government? Hmmm…sounds like something’s gotta give.

Poor Dermot Gleeson. The Irish economy is sinking…led by its banking sector. This makes bankers the most despised of all the Irish…and made Gleeson the target of egg-tossing shareholders at the annual meeting last week. The chairman of Allied Irish Bank had to dodge eggs while getting his message across – whatever it was. Warning to America’s bankers: get ready to duck.

So where’s the surprise for us? What’ll it be? Japan or Zimbabwe? We’ve already said we’re expecting both Japan and Zimbabwe. What else could it be? And we’re ready for them both.

Well, needless to say, we’ll be surprised like everyone else. And needless to say, we don’t know what will surprise us. But we have an idea. Almost everyone we know is expecting a fairly quick up-move in inflation. Our guess is that that up-move might be a long way off.

“It’s a very funny and troublesome situation,” said a fund manager in Boston last night. “The world’s central bankers are committed to a policy of monetary inflation…which they call ‘Quantitative Easing.’ And they believe that inflation targeting is the way they can tell if their policy is working. That is, they believe they will know when to stop inflating the currency by looking at consumer prices. When consumer prices begin to rise, they’ll be ready to stop adding to the money supply. In fact, they say they’ll then turn the machine to reverse to take out the extra cash they’ve added.

“So, they’ll keep at it until the CPI goes up. But by the time they see consumer prices rise, it will be too late. By then, people will be eager to spend…to get rid of dollars. And once they begin to spend again, the velocity of money will go up. And with it, inflation rates will go up higher…and then dollar holders will want to get out of bonds quickly…because they’ll see the next move too – a drop in bond prices.

“Well, how could the Fed combat this rising inflation? And prices could be rising very, very fast. It would have to go back into the market and sell those bonds that it bought from the Treasury. Selling the bonds would have the opposite effect as buying them. Instead of creating money with which to buy bonds, it would re-absorb money when it sold them. People would pay money for the bonds…and the cash would be sequestered by the Fed.

“So, you’d have the Fed trying to sell bonds just when everyone else was selling them. At that point, with the biggest bond buyer in the world turning into a seller, the Treasury market would collapse. This would paralyze the Fed. It might want to sell Treasuries. But, under the circumstances…with yields soaring and prices crashing…it wouldn’t be able. So all the inflation that it put in the system would have to stay there…and inflation would have to run its course.

“It’s very hard to know what to do as an investor. I guess in theory you should stay long treasuries…buy them as long as the Fed is buying. And then you should go short…sell them, just before the inflation numbers turn positive…and just before the Fed tries to sell. But that is going to be very, very difficult timing.

“I began buying gold for the first time ever last week.”

Until tomorrow,

Bill Bonner
The Daily Reckoning