Sunday, June 27, 2010

Two Fat Tails: Inflation and Deflation

We Simply Do Not Know

Keynes pointed out that in times of societal stress, we realize that, in looking into the future, we are looking into an abyss.

The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-paneled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface”.

More recently, Nicolas Nassim Taleb has discoursed on our “pretty, polite technique” of assuming that random processes are tightly distributed around a mean value. Our economists create probability distributions for future outcomes by fitting measurements of past realizations of financial variables into a Gaussian ‘normal’ distribution. In the language of statistics, they impose a ‘prior’ belief that events occur around some discernable mean; the further from the mean, the lower the probability of occurrence. This paradigm has held sway, in part, because most events do occur around a mean. Taleb has built a successful investment career by betting that the Gaussian assumption is wrong, that there are non-trivial possibilities of extreme events-so called ‘fat tails’ - which implies that, over time, such events will almost certainly occur.

Keynes was not so strident. He allowed a class of ‘well behaved’ phenomena who’s outcomes can be described by a Gaussian distribution. But there are important things that cannot be so described. They are subject to Knightian uncertainty.

By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know."

There’s Something Weird About Inflation Forecasts

Today, something weird is going on in the field of inflation forecasting. All the metrics of future US inflation expectations imply that people expect future inflation to be near the informal 2% target of the Fed. Indeed, Fed Chairman Bernanke assured some years ago that the Fed could counter deflation with a ‘helicopter’ drop of high powered money (and he’s made a creditable show of his prowess with the Fed’s unconventional monetary policy these past two years), and more recently he’s explained that the Fed can counter inflation by draining reserves from the economy with use of its new powers to pay interest on bank deposits at the Fed.

But people are worried. They feel that they “simply do not know” what is going to happen to prices over time. Few are soothed by Chairman Bernanke’s assurances. Why, then, is not a bias away from the benign forecast showing up in the inflation expectation metrics? It is because the uncertainty is so radical that we do not know which way the needle might move. But, unlike Keynes and Knight, we can place some bounds on possible outcomes. The distribution –if it is appropriate to describe it as such – is two tailed, with ‘fat tails’ for extreme inflationary and deflationary outcomes. Our predictions are like Buridan’s ass; we cannot choose so we are paralyzed in-between.

Two Fat Tails

Our uncertainty is well justified and simply explained. Inflation, for a given level of economic activity, is determined by three factors: (1) positively by the growth in base money – currency and central bank deposits in commercial banks- (2) positively by the increase in leverage among financial intermediaries and private parties and (3) negatively by the demand by the public to hold cash balances. Since the autumn of 2008, base money growth has exploded but has been offset by de-leveraging by banks and private agents, while the demand to hold dollars has fluctuated; increasing during crisis, when the dollar is perceived as a ‘safe haven’, and declining otherwise. The Fed has so far done a masterful job of manipulating its balance sheet so as to inject the right amount of base money to keep prices stable.

But we don’t know very much about how these variables will evolve over time, nor how effectively the Fed might counter their effects. One central concern over deflation is the continued need for banks and private agents to de-leverage. The danger here is that central banks have had great difficulty countering deflation when it sets in. The US was mired in a deflationary episode from the early 1930’s until WWII and Japan has net yet extricated itself from deflation, in spite of the most aggressive expansion in base money supply of any developed country in half a century.

The risk of inflation is all too apparent. If de-leveraging stops, if foreign investors begin to lose confidence in the solvency of the US government or the stability of the dollar exchange value in light of the unsustainable US trade deficit, there could be a flight from the dollar that would trigger a huge spike in inflation. Hovering above all this is the explosive growth in health related entitlements that could undermine the credibility of deficit reduction efforts in the US, increase US government borrowing requirements and, in a ‘flight from the dollar’ scenario, force the Fed to monetize US debt.

So here we are, stuck, like Buridan’s ass, between the two fat tails of inflation and deflation.

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