John Hussman: Charles Plosser and the 50% Contraction in the Fed's Balance Sheet

There are a few possible outcomes as we move forward. One is that the economy weakens, and the Fed decides to leave interest rates unchanged, or even to initiate an additional round of quantitative easing. In this event, it's quite possible that we still would not observe much inflation, providedthat interest rates are held down far enough. Unfortunately, the larger the monetary base, the lower the interest rate required for a non-inflationary outcome. T-bills are already at less than 4 basis points. In the event of even another $200 billion in quantitative easing, the liquidity preference curve suggests that Treasury bill yields would have to be held at literally a single basis point in order to avoid inflationary pressures.

A second possibility is that we observe any sort of external pressure on short-term interest rates, independent of Fed policy. In that event, the Fed would have to rapidly contract its balance sheet in order to avoid an inflationary outcome. As noted above, even a quarter-percent increase in short-term interest rates would require a full-scale reversal of QE2. Alternatively, the Fed could leave the monetary base alone, and allow prices to restore the balance between base money and nominal GDP. In order to accommodate short-term interest rates of just 0.25% in steady-state, leaving the monetary base unchanged at present levels, a 40% increase in the CPI would be required. I doubt that we'll observe this outcome, but it provides some sense of what I mean when I talk about the Fed pushing monetary policy to its "unstable limits."

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A third possibility is that the Fed intentionally reduces the monetary base, gradually moving interest rates higher as Plosser suggests. This is undoubtedly the best course, in my view, but it's important to recognize that there are already substantial risks baked in the cake as a result of the Fed's recklessness up to this point. The first 25 basis points will require an enormous contraction of the Fed's balance sheet. Risky assets have already been pushed to price levels that now provide very weak prospective returns. Our 10-year annual total return projection for the S&P 500 remains in the 3.4% area. Expected returns for shorter horizons are near zero or negative, but are associated with greater potential variability. Commodity prices have been predictably driven higher by the hoarding that results from negative short-term interest rates (if you expect inflation, but interest rates don't compensate, you have an incentive to buy storable goods now, and this process stops when commodity prices are so high that they are actually expected to depreciate relative to a broad basket of goods and services, to the same extent that money is expected to depreciate).