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Monday, June 25, 2012 2:24 AM

Is There a Limit on Central Bank's Ability to Inflate?

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On Friday, ECB President Mario Draghi announced ECB to Accept BBB- Rated Debt (One Step Above Junk) as Collateral. Reaction from the German central bank was immediate: Bundesbank Swipes at Draghi as European Fault Lines Deepen

“We’re critical of this,” Bundesbank spokesman Michael Best said yesterday. In terms of collateral, “we won’t accept what we don’t have to accept,” he said.

Fault Lines

Looser collateral is the latest issue to divide Europeans days before a summit that Italian Prime Minister Mario Monti said must succeed or risk a bond-market selloff. German policy makers are reluctant to put too much on the line to help debt- strapped nations before they fix their budgets and banks. French and Italian leaders are pushing for a wider range of crisis- fighting tools.

Those debates have flared on the ECB’s Governing Council too. Two years ago, the German central bank came out and opposed the ECB’s unprecedented decision to buy the bonds of distressed nations as part of a broader push to stamp out a crisis that was starting to spread from Greece. While the German central bank ultimately went along with the plan, it has since been largely shelved and deemed ineffective by most ECB officials.

Weidmann Letter

In February, Bundesbank President Jens Weidmann wrote to Draghi warning of the risks the ECB is taking in lending more than 1 trillion euros ($1.3 trillion) to banks. The ECB’s Target2 system, which calculates debts between the euro region’s central banks, shows that the amount owed to the Bundesbank has soared as Germany helps fund the region’s most indebted nations.

Earlier this year, the German central bank shunned another measure aimed at easing collateral requirements.

The ECB’s latest announcement is a “clear sign that the Bundesbank opposes any further increase in risks on the euro system’s balance sheet,” said Juergen Michels, chief euro-area economist at Citigroup Inc. in London.
Target2 and ELA Explained

If you do not know what target2 balances are, or if you want to understand how much Germany is really at risk of (most have it wrong), then please see Discussion of Target2 and the ELA (Emergency Liquidity Assistance) program; Reader From Europe Asks "Can You Please Explain Target2?"

Do Central Banks Face "Power Limits"?

In light of loosening collateral standards by the ECB to one step above junk, some might be wondering about limits on central bank actions.

The Bank of International Settlements (BIS) says Central Banks Face Power Limit as Debt Persists
“Central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed,” the Basel, Switzerland-based BIS said in its annual report, published today. “Both conventionally and unconventionally accommodative monetary policies are palliatives and have their limits.

“In the middle of all this we find the overburdened central banks, pushed to use what power they have to contain the damage,” Stephen Cecchetti, BIS economic adviser, said on a conference call. “There are very clear limits to what central banks can do. It’s critical for the health of the global economy to break the vicious cycles and reduce the pressure on central banks.”

“As the benefits of extraordinary monetary easing shrink and become less certain, the risks of expanding central bank balance sheets are likely to grow,” Jaime Caruana, general manager of the BIS, said in prepared remarks for a speech in Basel today. “Such hazards may materialize in ways that are not completely clear today.”

Loose policy also poses risks for developing nations by fueling credit- and asset-price booms, complicating efforts to stabilize price gains, the report said. In emerging economies, interest rates have been raised “only hesitantly” out of concerns about stoking further capital inflows.

On the debt crisis in Europe, the BIS said it’s “hard to escape” the conclusion that the solution to the crisis will have to include a pan-European banking system.
Politically Impossible to Avoid Breakup

Emphasis added to key ideas. I agree with all the points above except the last one.

I suggest it is “hard to escape” the conclusion that the eurozone will break up. Efforts to resist that breakup will only make the breakup when it does occur more violent.

Reasons To Expect Breakup

Key Breakup Idea 

Here is the key idea from It's Just Impossible

  1. The Bundesbank said there should be no banking union until there is a fiscal union.
  2. Angela Merkel said that there should be no fiscal union until there is political union.
  3. François Hollande said that there should be no political union until there is a banking union.
  4. The German supreme court will not allow a political union nor a fiscal union, nor a banking union without a German referendum

Central Banks Do Have Limits

Except as noted, I agree with the BIS position on limits. I have explained many times.

First note that the Fed (central banks in general) cannot give away free money. They can provide liquidity (but not capital). They will stretch what they are willing to do, but even in the case of the ECB accepting near-junk as collateral, it is only with a haircut.

For further discussion of liquidity vs. capital including some statements by a Fed governor, please see No Helicopter Drop For Failed Banks

Can The Fed Cause Hyperinflation?

I put together other key ideas in Hyperinflation Nonsense in Multiple Places. Here are some snips.
I do not think the Fed itself can cause hyperinflation and more importantly I am sure they would not if they could. The reason is "Hyperinflation Would End The Game"

  • Hyperinflation by definition would destroy the currency and thus the banks
  • Hyperinflation would destroy the wealthy and all their corporate bond holding
  • Hyperinflation would destroy the Fed
  • Hyperinflation would destroy the wealthy political class

To understand how powerless the Fed is, one needs to understand the difference between credit and money, how much the former dwarfs the latter, and what the Fed's role is in getting banks to lend. I discussed those ideas above and in far more depth in Fiat World Mathematical Model.

Note that the Fed has no power to give money away. Nor would they do so if they could.

Unlike the Fed, Congress could give money away.

I do not know if giving everyone in the US $60,000 would do it or not, but giving everyone $60,000 a month indefinitely would sure do it.

How likely is that?

The answer is 0%.

Theory vs. Practice

Please note that banks do not want hyperinflation or even massive inflation. The reason is simple: Banks will not want to be paid back with cheaper dollars, especially worthless dollars, and Congress is beholden to itself and the banks.

Hyperinflation could theoretically come from massive sustained political will to bail out the little guy at the expense of the banks, the wealthy, and the political class. However, unlike Mugabe and Zimbabwe, neither the banks nor the Fed nor the political class wants to bail out the poor at the expense of the wealthy.

Indeed, Bernanke's, Paulson's, and Geithner's actions to date have done the exact opposite!

We have bailed out the banks at the expense of the ordinary taxpayer (keeping the little guy in debt).

This is what it comes down to: In theory, Congress can easily cause hyperinflation. In practice, they won't, and neither will the Fed. As Yogi Berra once quipped "In theory there is no difference between theory and practice. In practice, there is."

Unlike super-deflationist Robert Prechter, I expect gold to hold its value over the mid-term (another swoon is always possible) as the Fed fights massive deflationary forces of excess leverage, excess debt, boomer demographics, global wage arbitrage, cutbacks in state and local governments, and most importantly - consumer attitudes towards debt.

In the final analysis, it's all about attitudes. The Fed cannot force consumers or businesses to borrow or banks to lend (and it wouldn't for reasons stated, even if it could). In a fiat credit-based system, that is what matters.
Attitudes the Key

In a credit-based economy such as the US and Europe, attitudes are the key. The Fed can print at will, but it cannot make consumers spend or businesses expand or hire.

The Fed is desperately (and foolishly) trying to get consumers to lever up once again, however attitudes of consumers have changed.

Boomers need to deleverage heading into retirement and Generations X and Y, are loaded up with student debt, struggling to find jobs. This is a deflationary setup, not an inflationary one.

For more on generational attitudes, please see Three Key Reasons Housing Not Coming Back: Demographics, Student Debt, No Jobs

Mike "Mish" Shedlock
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