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Hi Steve. I see zero "threat" of inflation now. While I would hardly presume to speak for Taylor, I doubt that he does either. That's probable bad, because a credible threat of inflation returning would mean the crisis is over. As long as the Taylor Rule interest rate is multiple points negative, ouch, the current danger is all the other way. All the quantitative easing is meant to deal with that. Taylor in that piece is warning of the future effects of the zooming up national debt. He's in the camp that thinks Obama has made the future now, debt-wise -- in that the national debt as a percentage of GDP was projected shoot up without end starting circa 2016, but now Obama's planning to double it *by* 2016, so the projected shooting up without end has already started. Taylor mentions the warning Britain just received on its credit rating -- but he doesn't mention that both Moody's and S&P have projected the US national credit rating to start falling in 2017 ... and they did that *before* Obama decided to double the national debt as a %-of-GDP by then.
Toggle Commented May 28, 2009 on Inflation Watch at The Skeptical Optimist
Deficits don't cause inflation -- monetizing deficits because you don't have the discipline to pay the tax cost of carrying the debt they create causes inflation. A warning from John Taylor, of "Taylor Rule" fame, an economist who knows about fiscal policy: http://www.ft.com/cms/s/0/71520770-4a2c-11de-8e7e-00144feabdc0.html?nclick_check=1
Toggle Commented May 27, 2009 on Inflation Watch at The Skeptical Optimist
"... And meanwhile there is the speculation about lowering the credit rating of the United States. "Since I'm too young to remember, I'll ask: Was there talk of such non-sense in the late 80's and early 90's too?" Sovereign credit rating relates to "default risk" -- that a country simply won't pay on its bonds. Like Russia 1997, or Argentina how many times. In the bad days of the 1970s and early 1980s there was no credit rating problem with US bonds as to default risk -- but holders of US bonds took terrible losses due to inflation and very high interest rates which drove down bond prices. As a result the market added a significant "inflation premium" to the interest rate ("we won't be fooled again!") that increased the real interest rate on US bonds, which made it more costly for the US to borrow, and further punished existing owners of US bonds by driving down their price. (Inflating away debt is of course the *other* way to effectively default on bonds without legally defaulting on them). Going forward, I don't see why you'd think it "nonsense" to talk of future reduction in the credit rating of the US. It's pretty sophomoric to think: "I've always managed my finances responsibly by incurring only modest debt ... so I've *always* had a AAA credit rating, *forever* ... THEREFORE, from now on I can run up huge, massive amounts of debt without increasing my income, and my credit rating will never change, because my credit rating never changes!" Which is exactly what the US is doing, by all present projections. CHANGE your financial practices and you will CHANGE your credit rating. Question: If the US runs up an amount of debt relative to national income that would justly and fairly give any other country a BBB credit rating, why wouldn't the US deserve a BBB credit rating too? Here's some data on how the US is running up debt... http://www.scrivener.net/2009/04/real-federal-budget-defict-for-2008-3.html At the bottom is a chart from S&P projecting the future credit rating of the US (and other developed countries) on then-current law. You can click through on the link under the chart to the full S&P report. Since then, Obama has announced he plans to add $7 trillion more to the debt than is considered in those projections.
"... higher demand for all forms of investment which should lead to lower interest rates in aggregate world wide. Common sense or not?" The interest rate is the price of borrowed money. Higher demand for investment means higher demand for borrowed money to fund investments. And higher demand for anything increases its price. So economic booms increase the real interest rate by increasing the demand for borrowed money, and recessions lower the interest rate by reducing the demand for borrowed money. Always. Look at every business cycle in history. Did interest rates zoom up during the Great Depression as global wealth and demand for investments collapsed as at no other time ever -- then plunge afterwards as wealth and demand for investment recovered to the norm? Then, again, there is the fact that the normal "rates drop during a recession" effect has been *compounded* this time for US bonds by the investment-sector's world-wide rush to Treasuries -- creating the "bubble" Buffett warns of. E.g.: at his just concluded shareholders meeting Buffett told the story of how Berkshire has made great gobs of money selling Treasuries that are soon to mature at far *above* their face value (which drives the interest rate they pay *way down*) which *guaranteed* the buyers would take a *loss* on them -- something Buffett said was previously unheard of in history. The reason is that across the world there are huge amounts of financial arrangements involving banks, insurers, whomever, in which if the borrower's credit rating/status falls below a certain level it has to provide US Treasuries as security to the lender. (See: AIG) With the global recession, all these borrowing covenants activated *at the same time* creating a panic rush into US Treasuries that must be purchased *at any price*. Thus the bubble -- and plunge in interest rates on US Treasuries If you don't believe, go to Bloomberg and check the interest rates paid over the last year on US Treasuries versus AAA-rated state tax exempts. Historically, because Treasuries are taxable, and state-issued tax-exempts are tax-free, state tax exempts have always paid *lower* interest rates than Treasuries to equalized the after-tax rate paid to investors. But over the last year, state tax-exempt bonds have paid *higher* interest rates than Treasuries. That is, to buy taxable income from Treasuries costs *more* than to buy *tax free* income from tax exempts. Say: Bubble in the price of Treasuries. At the same time, obviously, Treasuries have paid a *lower* interest rate than tax-exempt state bonds. Say: Abnormally low interest rate paid by Treasuries.
"How can you define 'normal' interest rates?" The historical long-term average for US bonds is about 3 points above inflation. "When the recession is over, World GDP will probably resume normal growth in excess of US 60 trillion per year (as of 2008)." Of course, and accelerating growth always *increases* interest rates. Recessions always reduce them. In this recession this effect has been greatly magnified for US bonds by the world-wide "flight to quality" as investors all over the world ran into T-bonds for safety. This tremendous increase in demand for US bonds has driven their price up to historic highs, and thus driven the interest rates they pay (which move inversely to bond prices) to historic lows. As the recovery begins to be felt and this process unwinds, money will go out of US bonds back to where it came from, US bond prices will fall back to normal, and bond rates will thus rise back to normal. Warren Buffett (no bear on America!) warns that US bonds now are experiencing a price bubble he compares to the home price bubble and Internet/tech stock bubble of 1998-2001 -- and he is warning average investors "stay out of US bonds!" "There is a heckuva lot more money out there today that will, inevitably, find it's way to the world's richest and safest country." It already has! In a great panic too! That's why the bubble that Buffett is warning about, and why rates are so low. When the panic is over and the owners of that money feel it is safe to take it home the bubble will deflate, bond prices go down, and interest rates go up.
Interest rates matter to interest expense too. During Clinton's reign the long bond rate was generally 6% to 7%, over the last year it's been 2.8% to 3.8%, and T-bill rates actually went *negative* for a short while. Unhappily, the Clinton-era rates are normal ones for a low-inflation economy, today's rates are an abberation that will disappear with the economic recovery. The sooner the economy gets back to normal, the sooner rates will go up. Alas, there's no way Obama can add $7 trillion to the debt with *rising interest rates*, probably doubling rates, and have interest expense as a part of GDP stay down. That circle won't square.