[quote=EconProf]Historically, rapid increases in the money supply and generally liberal fiscal policy combined with stimulative monetary policy has resulted in inflation. This inflation prompts higher interest rates, which causes the market prices of existing bonds (with their fixed interest rates) to fall.
We’ve now had many years of such monetary and fiscal stimulus and yet have low inflation and still-falling interest rates. Do the old rules no longer apply? Or do they just not apply yet, and will some day hit us with a vengence?
I’ve been wrong myself in predicting a return of inflation and rising interest rates, so am giving up on predictions.
The old rule about the time lag between a change in monetary policy and the resulting impact on the real economy–whether to tighter or looser–was about eighteen months. Well, that rule is certainly out the window.
It appears that other forces that affect inflation, interest rates, and expectations are overwhelming the stimulative effect of easy money: The deep recession, deleveraging, and especially the economic weakness of the rest of the world making the dollar look relatively safe.
For those of you who believe inflation will result eventually, shorting bonds is one way to put your money where your beliefs are.[/quote]
We are kind of in uncharted waters. Predictions of high inflation are pretty consistent with most economics theories. I’m no particular fan of the federal reserve bank, but their actions over the last 30 years have been pretty masterful. We can pretty much forget what their stated mission is, they’ve had mixed results in doing what they’re theoretically supposed to do. But forget what they’re supposed to do. Their real mission is to protect their member banks. And the biggest threat to member banks is inflation.
Banks are debt holders. That’s what they do. They nickel and dime us for services but they make their money by the spread between what money costs them to rent and what they earn by lending it out. Banks bear the risk of inflation. It is their achilles heal. High inflation will kill them. So the fed will protect against it all costs. The byproduct of their unpredictable and resounding success is wage stagnation. I really have no idea if that was the plan. Maybe it was not just the byproduct. But it is the result.
The next step is problematic. If we do see wage inflation, the fed will jack up interest rates. If interest rates go up, the value of long term debt falls, and banks suffer. So the fed has to walk a tight-rope. Their actions will cause damage to their primary protectorate (the banks, not the conomoy as a whole), so as to prevent even greater damage that higher inflation will cause.
No predictions. I’m just convinced that the fed will do what it can to protect banks above all else. Which means they will do whatever they can to reduce the risk of bonds collapsing.
