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Capital Markets

To Paul Krugman's chagrin, Volcker and the BIS swim against the deflationary tide

Before lambasting Paul Volcker and the Bank for International Settlements for sounding the alarm over the inflationary impact of lax G7 monetary policy – even in the face of a deflationary cycle – take a moment to consider the defence.

Paul Volcker

The godfather of inflation-slaying Paul Volcker, the famed former Fed chief that hiked rates – in the teeth of market resistance – to a peak of 21.5% in 1981, weighed into the US monetary policy debate with a stark warning on Wednesday. Speaking before the Economic Club of New York, Volcker said the Fed’s nominal GDP-focus threatened to unleash inflation. “Credibility is an enormous asset,” he said. “Once earned, it must not be frittered away by yielding to the notion that a ‘little inflation right now’ is a good thing to release the animal spirits and pep up investment.”

In comments that feed the Zero Hedge crowd – hard-money advocates from the Austrian economics school – Volcker said inflation “is hard to control and reverse”. He also charged that the Fed was embroiled in manifold conflicts, including navigating “misguided fiscal policies” and “structural imbalances”, while balancing the competing objectives of economic growth and inflation.

No doubt Volcker’s intervention will fan the flames of ire of Nobel Prize-winning economist Paul Krugman, the famed Keynesian and scourge of inflation-targeting puritans.

Krugman recently lashed out against Volcker’s presumptive ideological allies in a post called The Sadomonetarists of Basel, where he lambasted Jaime Caruana, general manager of the “central banks’ central bank”, for calling for G7 rate hikes to avert the threat of asset bubbles and elevated price pressures.

Krugman said: “In fact, inflation is running below target just about everywhere. You might therefore think that the BIS would step back a bit and reconsider both its policy recommendations and the framework it uses to derive those recommendations.”

Indeed, on the current trajectory, inflation is uncomfortably low and QE has failed to boost the money supply, as these charts lay bare:


Excluding food and energy, US CPI was up only 1.7% in April, still below the Fed’s 2% target, a challenge vexing most leading central banks, with the notable exception of the Bank of England (BoE), with UK prices rising 2.8% year-on-year in March.

Central bank-created liquidity is chasing financial sector assets. However, falling commodity and manufacturing goods prices represent a global deflationary threat, reckons BCA Research, while central banks’ balance sheet expansions have failed to feed the broad money supply, amid deleveraging and a reduction in bank lending.


In short, recent inflation figures suggest deflation remains a bigger threat than inflation, a risk that has not gone unnoticed by William Dudley, president of Federal Reserve Bank of New York.

Against this backdrop, Volcker’s comments swim against the tide. However, for a change, here are some points in defence of the BIS-Volcker crowd, from Finn Poschmann, vice-president at the Toronto-based CD Howe Institute, and a rare critic of incoming BoE governor Mark Carney’s monetary zeal.

Poschmann reckons Volcker and the BIS are raising legitimate concerns about the dangers of monetary laxity. Asked whether the BIS has damaged the credibility of inflation-targeting puritans by sounding the alarm on price-stability fears in 2011, a prospect that has yet to materialize, Poschmann notes: “The BIS reasoning in 2011 is consistent. The depth and length of the EU’s slide, and the sovereign/ECB debacle, have prevented the growth of money from manifesting itself, as of yet, in rising inflation expectations.”

He adds: “Caruana’s observation was that a widening gap between what a central bank might be able to do, and expectations for what they can in fact deliver, will harm their credibility – that is unarguably true, and true for any institution.”

He thinks commentators are vastly understating the ability of central banks to deliver both high inflation and low growth. “I have no doubt about the capacity of monetary authorities in the EU to deliver both inflation and lousy growth [has anyone looked around in the UK?],” he says.

“It is the nastiness of that outcome, and how rapidly it can sneak up on you, that I do not think Krugman appreciates.”

The negative consequences of monetary stimulus are said to include asset bubbles, growing liabilities for pension funds amid financial repression and the prospect of QE depressing the velocity of money, offsetting any increase in base money. Even if you think these risks are overstated, Poschmann says: “Caruana also draws a link, correctly in my view, between financial stability and inflation stability.

“Some variation in inflation is fine, but not to have a target for it, or to consistently head toward that target, will undermine the target, the institution and financial stability.”

Asked whether the fact the BIS – which represents central banks – and IIF, a bankers’ lobby group, are warning about loose monetary policy, is like a drunk warning about the dangers of alcohol while effectively injecting ethanol into their veins, he says: “Central bankers are political creatures, and together with their masters are happiest keeping the drinks flowing at the party.

“At the BIS, however, they intersect with regulators, who tend to take a more jaundiced view of the free-flowing wine. Collectively, they tend to iterate towards a minimal degree – the maximum jointly acceptable degree – of restraint on bank activities.

“In the last couple of years, G20 leaders have promised their voters to ‘fix things’, primarily through central bank actions.”

He concludes: “This was always a bit of a stretch. And now, the central banks are keeping the money flowing to jump-start something without causing inflation to break loose, and the regulators are trying to manage other banks’ conduct by fiat and by capital standard. Neither mission is likely to be fully successful.”

With the de facto promise to anchor their monetary policy through the explicit lens of economic growth in the UK, Japan, US, and, to a lesser extent, in the eurozone, this politicization of central banking means monetarism is a very different beast from what its ideological proponents originally intended.  

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