UBS’ Hatheway: US Could Handle Soaring Inflation Rates

Monday, 12 Nov 2012 12:43 PM

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Loose monetary policies designed to stimulate the U.S. economy have many afraid that inflation rates might soar as a result.

So what, one economist says.

When inflation hits without surprising the economy and markets, as might be the case in the United States, damage is much less severe, said UBS Chief Economist Larry Hatheway.

Editor's Note: 'It’s Curtains for the US' — Hear Unapologetic Warning from Prophetic Economist.

Even hyperinflation can be controlled if it strikes in line with expectations.

“To take an extreme position, one can make the economic argument that there are only limited costs in having inflation running at 1,000 percent per year, with one caveat. 1,000 percent inflation is perfectly acceptable, as long as the 1,000 percent inflation rate is stable at 1,000 percent, and it is anticipated,” Hatheway wrote in a note, Business Insider reported.

“Of course, one can argue that high inflation tends to be associated with high inflation volatility and uncertainty (and that is true empirically), but economically it is the volatility and uncertainty that does most of the damage.

The Federal Reserve recently announced plans to buy $40 billion in mortgage-backed securities held by banks every month until the economy and labor market improve, a monetary policy tool known as quantitative easing (QE).

The announcement marks the third time the Fed has rolled out QE measures to jolt the economy since the 2008 financial crisis, with the first round seeing the Fed snap up $1.7 trillion in mortgage securities and the second round seeing the Fed buy $600 billion in Treasury securities held by banks.

QE aims to stimulate the economy by injecting the financial system full of liquidity via asset purchases that push down interest rates to encourage investing and job demand.

Side effects include a weaker dollar, rising stock and commodities prices and fears inflation rates will soar once the economy gains steam, especially in the wake of the sheer volume of liquidity the Fed has injected into the economy.

Uncertainty, however, poses a bigger threat.

“The maximum damage from inflation comes if it is unexpected or if it is unpredictable,” Hatheway wrote.

An investor expecting inflation to soar wouldn’t buy a 10-year bond carrying a 1 percent yield only to see the value of his or her asset eroded by rising prices, he noted.

“Unpredictable inflation is damaging because it causes uncertainty over an investment time horizon — and that uncertainty is a risk that will demand a compensating premium,” Hatheway added.

“What the inflation uncertainty risk does is raise the real cost of capital. If I think inflation will be 3 percent but I am not sure whether it will be 3 percent, 0 percent or 6 percent, I am likely to demand compensation for the 3 percent inflation risk, but then additional compensation for the possibility that the inflation risk is as high as 6 percent,” he added.

“The additional compensation is an addition to the real cost of capital.”

Some Fed officials have opposed the U.S. central bank’s loose policies over fears monetary easing and low interest rates will stoke inflationary pressures, most notably Richmond Federal Reserve President Jeffrey Lacker, who dissented against several Federal Reserve decisions.

Growth might not resume as a result of Fed intervention if even inflation rates do rise.

“[T]he behavior of inflation is fundamentally attributable to the actions of the central bank, while growth and labor-market conditions are affected by a wide variety of factors outside the Fed’s control,” Lacker recently told a business conference in Roanoke, Va., according to prepared remarks from his speech.

Editor's Note: 'It’s Curtains for the US' — Hear Unapologetic Warning from Prophetic Economist.

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