Monday, April 25, 2011

Hussman Weekly Market Comment: Monetary Policy in 3-D

Last week, my friend John Mauldin reprinted our April 11 market comment Charles Plosser and the 50% Contraction in the Fed's Balance Sheet . John told me that he had received several nearly identical questions, along the lines of "Wait, now I'm confused - I thought that the Fed reduces inflation pressures by raising interest rates. Why would higher interest rates trigger inflation?"

So, this is where that phrase "external upward pressure" comes in. We have to distinguish between what economists would call an "endogenous" increase in interest rates - one that the Fed itself provokes by reducing the monetary base - and an "exogenous" increase in interest rates - one that is produced by changes in the behavior of investors and the economy, independent of actions by the Fed.

See, when the Fed decides to raise interest rates, it does so by reducing (or slowing the growth) of the monetary base, which can reasonably be viewed as an "anti-inflationary" policy. However, if interest rates rise independent of any change in the monetary base, then cash - which doesn't bear interest - becomes a "hot potato" that is suddenly less desirable. In that case, you get one of two outcomes: people holding cash may bid up Treasury bills, lowering short-term interest rates to the point where people are again indifferent between cash and non-cash alternatives, or failing that, the attempt to get rid of cash holdings in other ways provokes inflation and a depreciation in the foreign exchange value of the dollar (which was the outcome in the 1970's).

As I've argued elsewhere, one of the primary sources of exogenous inflationary pressure is growth in unproductive forms of government spending (spending that creates demand but does not expand capacity or incentive to produce), but I'll leave that feature of the argument for another time.

Monetary Policy in 3-D

The extreme stance of monetary policy is such a critical factor in the financial markets here that it is worth spending a bit more time on the relationship between interest rates, inflation, and the monetary base.