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Timing Will Be Everything In Avoiding Absolute Disaster

By Andy Shaw | January 26, 2010

Originally posted 18th September 2009

This article is just covering something that is likely to be a problem to us in a few years’ time. It is not on the horizon now, however, if you are aware of it then you will see some talk of it in the media and it will give you a good indication of what will happen when, without the mythical need for clairvoyance.

As we all know the Bank of England are currently engaged in the policy of Quantitative Easing (Printing money). This should equate to the value of money going down, but we won’t see that for a while. Anyway, when this phase has finished and inflation looks like it might start the government/central bank will have to switch from this policy to a tighter one and if they do not time it well then this will cause a lot of problems.

Timing this is somewhat tricky and they will get it wrong; too soon and the recession/depression will be extended, too late and we will have rampant inflation like in the 70’s. History has shown us that they will do it too soon (which is nice), and there is no reason at all to believe that this lots approach will be any different to the ones who ran it before. This mistake made in the 1930’s led to an extension of the depression by several years.

Their mistake will not just be because they are too conservative or incompetent but because this is really hard! What’s more they may not even get to do that, they may be faced with the play of simply having to choose between a slower economy and/or inflation/deflation.

“By mid-1936, the Federal Reserve lifted bank reserve requirements, in an attempt to soak up liquidity and prevent speculation from returning to Wall Street. However, the banking system was still too fragile and in need of capital. Consequently, both narrow and broad money growth plunged from a healthy clip back into negative territory. To make conditions worse, by 1937 fiscal stimulus programs ended and social security taxes were collected for the first time. The federal deficit shrank rapidly from -5.4% to -1.2% of GDP, creating significant contractionary forces.”

When we do start to come out of this the policy of a 2% target on inflation will mean that the central bankers will be trying to undershoot the target so as to not to allow it to go to far, and by doing this they will be dampening the economy just because they are trying to stick to an unrealistic target. I have argued for a long time that I thought a 2% target was too low but I doubt this lot will be nimble enough or creative enough to adjust this target to allow the economy time to breath properly and get itself going again. So I see this as being a ridiculous restraint when the time eventually comes as afterall, the inflation will have undershot for several years so there is obviously some elasticity in there and it wouldn’t hurt to bounce to 5 to 7% for a year or two before dropping back to say 3 – 4%. This is what would be needed to give the economy the slack it needs. I think the central banks know this, just that they will not get it agreed by the government as there will be political fallout from it and so they will not go with it.

What all this will probably mean for us is a sudden rise in interest rates, or it would have done, but now that they are so low they are going to have to be exceptionally careful when raising rates. If rates raise too fast even a 2% rise in a year could prove catastrophic as this would probably mean at the very least a doubling of mortgage payments, which would be excruciating to the economy. The majority of humans adjust to their current level of excess income quickly but adjust to a reduction in it slowly and that causes problems.

Don’t worry, we are a long way off rate rises. First they have to create inflation and they aren’t anywhere near doing that yet and we really do want them to do that at some point. So when they do create it you’ll have to watch the adjustment closely so as not to be caught as most will.

My advice at the moment continues to be very cautious and avoid anything with large potential losses. It really is a time to be certain of your moves rather than take chances. If you have educated yourself and you are in doubt, then there is no doubt; simply find a better deal.

Best wishes

Andy

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