This reminds me of the time I was following the macroeconomic commentary of a bank economist during the 1990s. As the economy recovered from the recession earlier in the decade, he kept warning about inflation reappearing. His warnings went on for a couple years – yet inflation remained well behaved. Then came news his reports were no longer available. He had been let go by the bank.

I wonder if the inflationists this time around will similarly discover that their fears were misplaced. In March, the U.S. consumer price index (CPI) fell 0.4% year-over-year, the first decline in half a century. The core CPI was up 1.8% — mostly due to an increase in cigarette prices.

But what really makes one question the inflationary thesis is the amount of slack in the economy. As the Financial Times of London reports, the Congressional Budget Office calculates the “output gap” will be 7% in 2009 and 2010. They don’t expect it to be closed before 2015. Prices don’t normally start going up until the “output gap” is a lot smaller.

Many people, including several well-known investors, have been calling for a bursting of the bubble in U.S. government bonds. I have been looking at going short with the ProShares Ultra-Short 7-10 Year Treasury (PST) or ProShares Ultra-Short 20+ year Treasury (TBT) exchange-traded funds. However, until there is a resurgence of inflationary pressures, the decline could be less dramatic that what might initially be expected.

Soros joins a lengthening list of  luminaries warning of a tumble in government bond prices (which I am looking to play with exchange traded funds that track the inverse of bond prices):

“When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s,”  writes Warren Buffett in his latest letter to shareholders.  “But the U.S. Treasury bond bubble . . . may be regarded as almost equally extraordinary.”

Kenneth Rogoff, an economics professor at Harvard University and former chief economist of the International Monetary Fund, is in the same camp. Mr. Rogoff says annual inflation could go as high as 8% to 10% within three to five years in the U.S., and sooner in the U.K. That can have a big impact on bond prices. If, for example, investors expected U.S. inflation to rise to 8% to 10% a year, the price of the 10-year U.S. Treasury bond would have to be about 25% lower than it is now.

“Government bonds may be the last bubble that is developing,” says legendary hedge fund investor Jim Rogers. “I plan to sell short US government long bonds sometime in the foreseeable future… I don’t know when, whether it’s this quarter or this year.”

There are naysayers. For example, one commentator, Mark Sadowski, says: “The risk of a bond bubble is much overdone. It is instructive to see what happened to Japanese government bonds….”  

But it would be a mistake to see the government as powerless. As the recession deepens, it gives the Federal Reserve more scope to monetize debt and other assets. The amounts of new money created will be large, and inevitably will bring out louder prophecies of hyperinflation and other doom-and-gloom scenarios.

But before the wave of new purchasing power reaches an inflationary threshold, the economy has to experience an upswing and reach full employment. That could be another two years or so, given the customary lags – lots of time to make a good return in the stock market. The SPDR S&P 500 ETF (SPY) could very well be 20% to 30% higher by the end of 2010 or at least by mid-2011.

Presumably, as the economy approaches full employment, the Federal Reserve will act to withdraw liquidity from the economy. It won’t let the economy shoot off into galloping inflation, as many of the gloomy prognosticators seem to be overlooking. Granted, the ride will not be smooth.

As for a collapse in the U.S. dollar and soaring U.S. interest rates, they are not likely to happen while emerging countries continue to repress their currencies in efforts to boost exports to the U.S. and the developed countries. That means they should have accumulations of U.S. dollar reserves to recycle back into U.S. bonds and other assets.

On the other hand, he is described as having “a prodigious brain, a tremendous knowledge of past financial crises.” He’s “a very powerful thinker” and in “most situations, he is the smartest guy in the room.”

The article is definitely worth a read. It gets bit dry in places but sparkles in others. One highlight was the account of Bernanke’s first meeting with the President and the Vice-President after being sworn in as chairman of the Council of Economic Advisers in 2005:

“After he … sat down in the Oval Office, President Bush noticed that Bernanke was wearing light-tan socks under his dark suit. “Where did you get those socks, Ben?” he asked. “They don’t match.” Bernanke didn’t falter. “I bought them at the Gap—three pairs for seven dollars,” he replied. During the briefing, which lasted about forty-five minutes, the President mentioned the socks several times.

The following month, Hubbard’s deputy, Keith Hennessey, suggested that the entire economics team wear tan socks to the briefing. Hubbard agreed to call Vice-President Cheney and ask him to wear tan socks, too. “So, a little later, we all go into the Oval Office, and we all show up in tan socks,” Hubbard recalled. “The President looks at us and sees we are all wearing tan socks, and he says in a cool voice, ‘Oh, very, very funny.’ He turns to the Vice-President and says, ‘Mr. Vice-President, what do you think of these guys in their tan socks?’ Then the Vice-President shows him that he’s wearing them, too. The President broke up.”

Past blog posts (from Investing Ideas) on the Federal Reserve and financial crisis:

Getting ready for the next panic (Wed. 22 Feb., 2006)
A wilting of U.S. consumers and retail stocks (Fri. 21 Apr., 2006)
The Federal Reserve and the Polar Express (Tues. 25 Apr., 2006)
Avoid/sell U.S. bank stocks (Fri. 2 Jun., 2006)
Daddy, look at the cute mortgage lenders! (Tues 26 Sep., 2006)
Banking system risk is climbing (Mon. 9 Oct., 2006)

Paul Volcker, as you may recall, was Fed chairman from 1979 to 1987 and he was credited with taming the double-digit inflation of the 1970s. He was successful because he was given a free hand. Now it’s time to institutionalize greater independence in the Fed so we can have more Paul Volckers, writes Hutchinson.

That means making the Fed less of a decentralized institution. It also means doing away with the dual mandate to promote both price stability and full employment in favor of a primary focus on price stability.

I would add that price stability should be defined with reference to asset prices as well, not just prices of consumer items. In my opinion, the monetary excess was not just a reflection of political meddling and a dual mandate but also a policy error – i.e. an inappropriate definition of price stability that allowed monetary policy to become too loose.

“The power of traditional monetary policy may nevertheless be limited in the present situation …. jammed credit markets mean that any cuts will take more time than usual to filter through to the economy … with banks reluctant to supply new credit in the first place, overall benefits are capped … to boost the real economy directly, the central bank needs to be supported by fiscal policy.”

Danielle Park in her Juggling Dynamite blog, says cut to 1% won’t have the same stimulus as the 1% cut in 2003:

“the world economies are in a lot worse shape now compared with 2003. Back then we just had a stock market bubble and the after shocks of 9/11 to deal with … I doubt that this 1% will have the same simulative effect as the last 1% did in 2003 …. the cut to 1% in 2003 did not work right away even then. They left rates at 1% for one full year before consumption picked up meaningfully in 2004 …. secondly, consumers also had a lot less debt in 2003 than they do today.”

More on the liquidity trap by Robert Brusca, chief economist at FAO Economics:

“Banks are like roach motels. The rate cuts go in but they don’t come out,”

So we could see more of this.

But it is commonly believed the Great Depression had its origin in policy errors. The Federal Reserve had nearly halved its discount rate by 1931 and there were signs of stability emerging. Then, concerned about the outflow of gold caused by lower interest rates (U.S. was on the gold standard at the time), the Fed hiked interest rates by the largest amount since it’s founding in 1914 — and turned a recession into a depression.

So, if the Fed can avoid committing such policy errors, a monumental banking crisis need not entail a depression and 25 years of no gains in stock markets. And given the current Fed chairman is an ardent student of the Great Depression, the odds are looking good such mistakes won’t be repeated. 

If one still feels the urge to sell, how about waiting for market rallies? As I recall, the two greatest rallies in U.S. stock markets occurred in the midst of the Great Depression. Extreme bouts of pessimism are the mother of extreme upward moves it would seem; over the three months to September of 1932, the S&P 500 rocketed upward by 150%. The index then lost 25% of its value over the next three months, and returned to an upward trajectory over the first half of 1933, gaining 120%.

Besides, there is no need for higher Fed rates if inflation is going to moderate on its own. Some may think negative real interest rates are a stimulative monetary policy bound to accelerate inflation — but policy remains restrictive, according to Sherri Cooper, chief economist at the Bank of Montreal.

That’s because of the credit crunch. As the Fed’s April survey of loan officers showed, there “has been a record level of tightening” in U.S. credit standards. Going by my very rough calculations, this puts the effective Fed rate closer to the 3.75% rate recommended by the Taylor Rule.

Lastly, for inflation to enter a runaway phase, wages need to begin rising too. However, workers don’t have much bargaining power when job losses are piling up. The chances of a wage-price spiral commencing appear to be rather small.

So suggests BMO Nesbit Burns strategist Michael Herring in a recent publication. The banks can borrow the cheap funds and buy higher-yielding Treasury and agency bonds, pocketing the spread in yields to replenish their balance sheets over time.

This “carry trade” is what happened after the savings and loan crisis nearly 20 years ago. “The Federal Reserve held the Fed Funds rate at 3% for almost a year and a half so the banks could borrow cheap and buy U.S. government bonds to rebuild their balance sheets,” writes Herring.

But the Federal Reserve is not running the “printing presses” any faster and Bernanke’s helicopter is gathering cobwebs in the hangar. True, the Fed’s efforts to stabilize the financial crisis through the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PCCF) is expanding liquidity. But as the economists at Northern Trust indicate, the Fed has also sold $230 billion (U.S.) of its U.S. Treasury bond holdings to private-sector banks over the four months to April 23. This has drawn liquidity out the financial system, roughly offsetting or “sterilizing” the expansion in liquidity arising from the TAF and PDCF.