Dr.Brendan Brown's Latest Publication

Available in soft back or digital.

The greenback as a long-run store of value: Clarida-Powell reforms, accelerate erosion  

What might the non-cynic have imagined the main purpose to be of any US monetary reform?

     Presumably, to enhance the dollar’s quality as money – most importantly, as a long-run store of value.  

      Yet, this just does not figure in the self-reform which the Clarida-Powell Federal Reserve is now conducting.

      Amazingly, for the first time in the 100 plus year history of that “making monetary policy” institution, Congress is not taking any role in the proceedings.

      Ultimately, the Fed is answerable to Congress, according to its founding legislation. 

      Yet the 2 per cent inflation standard came into effect, and now a reform is to be implemented, without Congress even signalling explicitly its approval, let alone undertaking a serious scrutiny of the issue. 

      Indeed, mid-1970s legislation specifies that the Fed pursues stable prices (not perpetual 2 per cent inflation), alongside high employment aims.

      All the leaks and hints point to an agenda of reform which makes more serious the commitment to perpetual inflation, at an average rate of 2 per cent per annum.   The Fed would respond in future to substantial periods of under-shooting of the 2 per cent target by symmetrically producing similar over-shoots at times.  Until now, policy has ignored bygones (inflation under-shoots).  

       Note, this hardened 2 per cent inflation regime (some would describe it as an amalgam or hybrid of inflation-targeting and price level targeting) still does not acknowledge the key notion of a natural rhythm to prices (of goods and services) through time.  “Natural rhythm” means the alternating (albeit irregular) downward pressure on prices (typically, during periods of resource abundance and productivity surge) and the upward pressure on prices (typically, during resource shortages and productivity downturns).  Central banks should embrace rhythm. 

      Rather, in the “reformed regime” which the Clarida-Powell Fed is now drafting (Professor Clarida is the Bernanke-ite vice-chair, last year installed at his post), the periods of above trend and below trend inflation would be administered according to central bank policy discretion. 

       Yes, an initial “inflation undershoot” may correspond to some natural rhythm downwards in prices, but how far and how quickly to respond to this would be a key policy issue – nothing automatic here.

Modern man lacks monetary comfort  

       Investors intending to allocate, over the long-term, a substantial share of their wealth to bonds and notes denominated in US dollars, have a keen interest in how far the purchasing power of this money evolves.  Hence, any change in Fed regime which has bearing on this is highly relevant to their decision-making.

    In modern idiom, the issue is how far the dollar’s purchasing power will sink within any given time frame, measured in terms of the US, globally, or in any other specific region. 

      They have grounds to be somewhat fearful about the Fed’s policy self-reform process, now under way.

      After all, the eventual aim of wealth accumulation is not the weight of 100 dollar bills under the mattress, but rather the amassing of broadly defined spending power over time.   Houses, jewellery, stock ownership, bullion bars, might all buttress that assumed power.

      The dilemma of “modern man”, in this respect, is quite different (and a lot worse!) than under the full gold standard, such as existed in the four decades or more up until 1914 (when the eruption of World War One brought it to an end, more or less). 

   This aspect of deterioration in the human condition, related to the “triumph” of fiat money, may seem odd to one-time economics students, educated in the dominant Keynesian folklore of the gold standard coming to an end (due to the “unacceptability in modern democracy” of the severe business cycle downturns, which it engendered on occasion along with related pains of deflation).   

      Then (pre-1914), the over-riding assumption and belief (founded in experience and principle) was that whatever happened, in the short or medium-term, to the vast array of prices of goods and services, in the long run, the broadly considered purchasing power of the dollar (or any other gold money) would eventually “revert towards the mean”. 

      There was no requirement to define this power in terms of fine formulae and econometric estimations. In some periods, the purchasing power of the dollar would shrink (the natural rhythm of prices upwards); in others, broadly symmetric over the long run, the purchasing power would expand (the natural rhythm of prices downwards).

After 1914, reversion to the mean no more

       The “reversion to the mean” was due to the automatic mechanisms of the gold standard – in particular, the influence of mining costs (in nominal terms) on the production of gold. 

     Of course, belief could not be rationally 100%.

     The gold standard could come to an end or a massive new source of chief gold supplies might emerge.

     Rational man might puzzle about those tail risks.  The over-riding likelihood, however, was that purchasing power would even out over the long-run. 

       In that climate of opinion and belief, there was limited interest (if any), in studying (or producing) complex measurements or purchasing power, all of which had severe flaws, albeit less than today.

       The normal expectation was that the actual purchasing power of monetary wealth, from the viewpoint of any particular saver and his or her possible spending plans, could fluctuate quite considerably over the short or medium-run.   Monetary wealth (including gold) could not be a reservoir of purchasing power characterized by zero or near zero volatility.  But savers could count upon a high-quality money most likely proving to be a safe store of value in the long run (albeit with some tail risks).

       Fast forward to the fiat money regime, starting with the outbreak of World War One and the simultaneous launch of the Federal Reserve.  This institution demonstrated, as soon as war ended, that reversion to the mean was no more.

       Instead of allowing prices to fall back sharply, as would have occurred when wartime shortages came to an end, under restored sound money conditions, the Fed stoked up further monetary inflation through 1919.   Amazingly, monetary base expansion continued at a rapid clip, as the Fed pushed back against a rise of interest rates.

       The extent of the immediate post-war boom and inflation took the Fed (and its New York Fed-based effective chief, Benjamin Strong) by surprise, and it reacted by a sudden sharp tightening of monetary conditions, which unsurprisingly brought the deep 1920 recession.  

        In consequence, the Fed came under huge political pressure to ease up and indeed did so, moving towards an unofficial targeting of stable prices, even though a tiny part of the previous rise had been reversed (and through the 1900s decade prices had been rising continuously in part related to a somewhat faster pace of newly mined gold supplies).    

         The Fed’s premature easing and then targeting of stable prices, when the natural rhythm of prices would have been downwards (especially given the growing global glut of commodities and productivity growth boom in the US), produced the giant global asset inflation of 1925-9, of which the German credit bubble and subsequently bust was a main feature. 

       The Fed made an even bigger perverse move, after World War 2, promoting severe monetary inflation by keeping both short and long-term rates fixed, at exceptionally low levels through 1946-7. There were no second thoughts this time, even temporarily, which would have echoed Benjamin Strong’s belated tightening, during the 1919 boom. The Korean War 1950-3) brought added upward pressure on prices (through induced shortages of some goods and services). 

Lessons from Chief Martin’s great inflations

        We read a lot in the standard historical texts of how newly appointed Chair Martin reversed course, entering into an Accord (1951) with the Treasury to desist from pegging long-term rates (at the low levels of around 2 per cent), and thereby encountering the wrath of the President (Truman) who had just nominated him.

       The reality, however, is that the Martin Fed never followed a monetary policy such would have ratified a fall-back in prices, once the Korean war was over – in defiance of what would surely have occurred under sound money conditions through the mid-1950s as productivity growth boomed.  The result was several episodes of monetary inflation – the early ones most evident in asset markets, the last (and greatest) eventually also evident in a break-out of goods and services, with reported inflation.

Chair Martin would never utter or write the word asset inflation.  The closest he got to that recognition was when he described the party in the asset market-places.  He claimed he was adroit at taking away the punch bowl before the party got too exciting, but it is highly dubious that he ever acted in that way.  Furthermore, under sound money the party would never have started.


      By the time Chief Martin was ever on the case (concerned about the partying), it was already very late, and he never had the stomach to persevere for long in enforcing abstinence.  He did enough nonetheless, to precipitate three recessions within so many years, a fact which helped win the 1960 election for President Kennedy and his new vision Keynesians.

Paul Volcker rejected a chance of reversion to mean

       Fast forward, did that modern hero of US hard money, Paul Volcker, ever give reversion to mean a chance? 

        Yes, he could have done so! In the early mid 1980s the OPEC cartel was crumbling and its benchmark prices collapsing; oil shortage had turned to glut, and Reaganomics was going along with a productivity growth boom. 

        Instead, at the first sign of growth cycle slowdown, the Chair relented and joined forces with the President Reagan’s newly appointed devaluation Tsar, James Baker, at the Plaza accord.  The result was the build-up of monetary inflation in the late 1980s – growingly apparent in both asset and goods/services markets.

       Without painstakingly continuing this history, as to how the Fed killed off (of course under ultimate political direction) any reflex reversion to the mean of prices (however weak), let’s proceed to see what this means for portfolio construction and inflation danger, in the present.

Lessons for portfolio construction

       We start with two observations: 

       First, in recent years under anything like sound money conditions, there would have been a powerful episode of reversion (downwards) of dollar purchasing power towards the mean.

      Digitalization and globalization, plus the bonanza of shale oil/gas, would have worked their effect.  But as has happened so often in the history of fiat money, the Federal Reserve has seized on the opportunity to throw a party for the asset markets – senior officials (and their political masters) would never admit that as the purpose, instead claiming that they were stimulating the economy.

     Second, any pretence that there is a meaningful concept of purchasing power of the dollar (or any other currency) defined by movements of a general price index has become even flimsier than usual.  Just think about the modern shopping basket – this no longer consists primarily of staples (food, utilities, travel) alongside stable rents.  Also, the degree of heterogeneity of the basket between different categories of households has increased enormously. 

      As examples of shopping basket issues, education and health services have become so more complex to define. 

      There are all these commentaries, to the effect that “quality” of US public schooling has deteriorated; but where is this factored into the quantity units which make up the US shopping basket.   Indeed, some argue that a whole range of services has deteriorated (as part of the shift to online and economization in personalized services). 

       In the health care sector of the economy, the definitions become even more complex.  How do we adjust quantities for increased power (life extending or life improving) of medical treatment? 

      Yet for the young, this may be barely relevant; for the old, highly relevant.   

      Moreover, in the health sector, statisticians are measuring price by the cost of insurance, rather than the cost of treatment.  Note, for the old, who get the benefits free (on Medicare), correct measurement should surely register their expenditures and tax subsidies (or grants) separately?  

       Housing cost issues are well-known. 

      Surely these modest fluctuations, in imputed rent as registered in the CPI over time, have no bearing on the run-up of rents which consumers of space in popular urban centres have confronted, during the present and previous house price boom?  

       Meanwhile these hedonic price adjustments (for quality) which bear particularly on computers and software, may make sense for technology-intensive consumers (who really appreciate, for example, the various aspects of improved computer power identified by the statisticians as justifying simulated price cuts), but not others in the overall community. 

Who appreciates smoothed 2 per cent inflation? Very few

         Bottom line: the central bankers and their masters might boast about attainment of 2 per cent inflation year by year.   But even if their boasts were accurate, a wide range of households would find much greater volatility (some adverse) in the key prices which made up large components of their particular shopping baskets. 

        For some, the total price of their basket (filled with items bought over many years) might rise cumulatively by much more than 2% p.a. on average, and for others much less.  The 2 per cent target over the short medium and long-run is little cause for overall comfort, as regards the evolution of dollar purchasing power for many individuals far distant from the hypothetical consumer of the CPI basket or equivalent.  These individuals might well be happier to experience less asset inflation, with all its ultimate costs, than be soothed by smoothed trend CPI growth. 

        In summary, It is not clear that policies, which seem to smother fluctuations in the official price indices around their gently rising trends, are in fact greatly meaningful, in terms of steadying the purchasing power of individual households contemplating particular expenditure streams (still uncertain in scope and timing).

       Most households, if they could articulate their preferences in this matter, might well prefer a reinstatement of long-run reversion of dollar purchasing power to the mean, rather than stabilization of general price increases – whatever that means, over short and medium-periods of time.    In the bigger picture, they might also prefer the tackling of asset inflation, even though the periods of speculative temperature rise might be popular, whilst they last.  

      Anyhow, households nowhere are about to be given the choice! 

       Instead, in a mood of realism, they would focus on how their portfolio of US dollar denominated assets could fare over the next half decade or more, as a store of value for their long-run spending streams, whatever that might be.

 The danger of greater falls in dollar purchasing power

      There are political economic realities which point to considerable falls in purchasing power of the dollar, in such a perspective.  

      All the opportunities for sustained price falls, alongside a natural rhythm of prices downwards (such as accompanying rapid productivity growth or resource abundance), have been squandered. Huge outstanding public debts pre-dispose the political authority, to favour suppressing interest rates during the periods of natural rhythm downwards, and generating asset inflation at such times. 

       Many years of abnormally low rates can help fund deficits which otherwise pose big problems.  In addition, the capital gains, which go along with the asset inflation, can yield quick fixes to the budget arithmetic, at least for some time.

        When the rhythm of prices shift upwards – perhaps due to waning of globalization and digitalization (in their effect on prices) or perhaps due to a curtailment of energy abundance (credit crisis affecting shale oil and gas or new political forces galvanizing action in reducing usage of fossil fuels)   – we should not expect such enthusiasm of the central bankers and their political elites, to smooth the passage of the consumer price index over time. 

        Rather, there will be special pleading as to why it is best to accept some extra rise in prices for now.   Such arguments have indeed plausibility, but as part of a case for allowing space of a natural rhythm of prices, both in an upside direction and downward direction.  

        So yes, we should beware of sudden transition from abundance to scarcity which would drive prices higher; and when abundance returns, the central banks will stand in the way of normal forces which would bring them back down again.

        On top of this, could there be a deliberate monetary inflation in the full knowledge and expectation that his will drive prices higher, at an accelerated pace?

        An endemic danger here is currency devaluation, most likely effected as part of a currency war offensive.  

      The maximum risk periods, for such offensives by the US, are recessions, especially where these are awkwardly close to a looming presidential and congressional election.

       That was a main story line in the passage of the US economy into its “Greatest Peacetime Inflation from the late 1950s to the late 1970s”(the dollar devaluation of 1971). 


        It was an element in the resurgence of US monetary inflation in the second half of the 1980s (Plaza ahead of a difficult Congressional election in November 1986).

Also, later in 2003-4 (when the Bush Administration broke up the Asian dollar bloc, and insisted on dollar devaluation) – culminating in year-on-year CPI rises in the US of around 4% in 2005-6. The aim of President Bush was re-election in 2004.

        We could imagine this Administration (or the next Administration), with an election looming, using its powers of influence over the Fed (including crucially nominations to its Board) to step up monetary “stimulus” whilst denying any monetary inflation intent.

      Think of how the Trump Administration could respond to an unexpected severe further slowdown in the US economy later this year, ahead of the November 2020 elections.     

       Monetary inflation may well show up eventually as higher recorded goods and services inflation.  But the identification and diagnosis of monetary inflation has become inherently more complex in our world, where monetary base is no longer at the pivot of the monetary system.   Investors should be aware that this can happen.  A portfolio of money and US bonds can suddenly suffer substantial erosion of real purchasing power – and financial history does not suggest that bond investors were well prepared for such eventuality.

Why bond markets do not warn of high inflation

       Bond yields did not warn of any of the past century’s sudden lurches into high inflation.  (Examples include 1916-19; 1942-7 and 1950-55; 1965-1978 and more moderately in 1987-90; 2004-6). Investors lost their real shirts. 

        The rise in bond yields came after the descent into high inflation was already well under way, not before, even though the risk was surely already there before, to an extent which could have been discounted in prices (of bonds). 

     There is no simple ready-made explanation for how bond markets seem to fail a strong efficiency test in this regard. The late Rudiger Dornbusch said that the bond market is made up of chickens who dart apparently madly in one direction and then another.  Kinder explanations (to bond investors) would stress the huge uncertainties.  

      A point to bear in mind here is that when the Day of Reckoning comes, for the present Great Asset Inflation, there will be revelation of much mal-investment and corresponding much over-employment (employment in occupations whish seemed viable under distorted conditions of monetary inflation).  Consequently, the “supply side” of the economy suddenly shrinks.   Central banks deploying their neo-Keynesian models would be very slow to pick up evidence in the new cycle of “excess demand creation”.       


Executive Summary

Should investors be concerned about the media buzz, which emanates from the Federal Reserve’s present re-drafting of its 2 per cent inflation target, and how this is to be implemented?

  The average inflation rate, which the Fed seeks over the long-run, is likely to rise somewhat.  The reality of a world without any money, that can seriously be considered as a safe store of value, becomes even more ugly.

  But there is no alternative fiat money which will gain in consequence of Fed re-drafting.  (Gold is a different story).  And don’t expect the US bond market to be in any way a sensitive indicator of danger.    The greatest near-term risk scenario (not central scenario) for US inflation break-out is a dollar devaluation, ahead of 2020 election.