'Nightmare Scenario' Could Lead to Stagflation

If distorting taxes leads to slow growth, and bailouts and entitlements are not resolved, the “nightmare scenario” for the U.S. economy would be stagflation, said John Cochrane, AQR Capital Management Professor of Finance.

“This is not a forecast, and there is still time to avoid it,” Cochrane said during a Myron Scholes Global Markets Forum, presented by the Initiative on Global Markets and the Chicago Council on Global Affairs at Gleacher Center on October 28. “But if this happens, it will surprise the Fed.”

In Cochrane’s “nightmare scenario,” a long-term federal budget problem triggers a flight from the dollar, which has already fallen in value, a rise in long-term interest rates, followed by inevitable inflation. In turn, Cochrane said, high marginal rates can lower long-term growth, which makes eventual deficits worse. For example, Cochrane noted that phasing out health insurance subsidies as income rises amounts to such a high tax rate, and distorts people’s incentive to work.

To consider the possibility of inflation or deflation, economists examine interest rates, money supply, and federal deficits, he explained. The Federal Reserve traditionally affects interest rates and the money supply by open market operations. “When the Fed buys government debt, they give people more money, but less government debt,” he said. “That might affect interest rates, and it certainly affects the amount of money out there.”

But these shifts do not affect the government’s fiscal picture, Cochrane said. “An open-market operation changes the composition of government debt – money is just a different form of government debt – but it doesn’t change the overall quantity.” Therefore, “When fiscal constraints take hold in either direction, there’s nothing the Fed can do about it.” He explained, “When a currency is about to collapse, as in Argentina, because the government does not have the resources to pay off its debts, there is nothing the central bank can do about it by raising rates, or trying to sell more debt to soak up money.”

Cochrane looked for inflation dangers in interest rates, money, and deficits. The biggest question surrounding interest rates is whether the Fed will raise them in time to prevent inflation, Cochrane said. “This is a serious issue. There will still be high unemployment and strong political pressure to keep rates low.” Moreover, because the Fed intervened directly in mortgage and other markets to lower rates, it is politically responsible for what happens in those markets, Cochrane worried: “When mortgage rates went up, the Fed used to be able to say, ‘Mortgage rates do their own thing. We’re just in charge of the federal funds rate.’ Now the Fed is buying mortgages and it’s in charge. If rates rise, every real estate broker in the country is going to call their congressman.”

Looking at money, Cochrane opined that the Fed’s attempts of “quantitative easing” by dramatically increasing reserves will make no difference in stimulating growth, but by the same token, large amounts of money in the system do not put the U.S. at risk of hyperinflation. “We learned in the 1980s that velocity changes over time,” he said. “When interest rates are near zero, money and bonds are the same thing, especially for a bank. If I ask you to give me yellow M&Ms and take the same number of green M&Ms, that won’t make any difference to your diet.” So, “The Fed loaned a lot of reserves to banks, and the banks simply sat on the reserves.” When it’s time to reverse that policy, Cochrane said the Fed will easily be able to, “What the Fed giveth, the Fed taketh away.”

Since neither interest rates nor money pose intractable inflation dangers, Cochrane concluded that the major inflation danger for the US at the moment is the unresolved long-term fiscal problem. Fortunately, he opined that we have several years before investors give up on our government’s ability to straighten it out.

                                                                                                                    — Phil Rockrohr