"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Thursday, February 11, 2010

John Hussman's extreme inflation forecast. Will the CPI double over the next ten years?

John Hussman runs the very successful $6.7 billion Hussman Strategic Growth Fund. I greatly admire Hussman's investment and risk management skills, so I was really surprised when I saw his inflation forecast:
At present, inflation risks are hardly considered to be problematic by Wall Street. From the standpoint of the next few years, my impression is that this complacency is probably well-founded, but only because we are likely to observe a second wave of credit losses that will create fresh "safe-haven" demand for default-free government liabilities. From a longer-term perspective, however, I believe that inflation will be a major event in the latter part of the coming decade, with the consumer price index roughly doubling over the next ten years. As exchange rates and commodity prices tend to be more forward-looking and less "sticky" than the prices of goods and services, it is likely that these markets will move substantially well before the eventual peak in CPI inflation.

John Hussman says government spending growth is the key driver of inflation and presents us with this chart:
Hussman uses quantity theory of money in his work, and prefers to use quantity of all government liabilities as his measure of money supply. Hussman observes the enormous increase of government liabilities during the crisis, and he sees no end of this process. He is worried about the doubling of the monetary base, he is worried about the cost of bailout of bondholders of insolvent financial institutions and he is worried of the nationalization of mortgage market. John Hussman says that likely near term worsening of the credit crisis will increase deflation concerns, but long term inflationary picture has a very strong foundation:
The past two years have seen an enormous issuance of new government liabilities. During the two years ended September 30, 2009, the amount of U.S Treasury debt held by the public (outside of agencies such as the Social Security Administration and the Federal Reserve) surged by more than 50%, from $5.05 trillion to $7.55 trillion. During that time, the Fed's holdings of U.S. Treasuries actually shrank by about $10 billion, yet the Fed has explosively increased U.S. monetary base from $850 billion to $2.02 trillion, fueled by massive purchases of Fannie Mae and Freddie Mac's mortgage-backed securities.
I think that the doubling of the CPI over the next ten years is very unlikely. First, Hussman's scenario of inflationary fire after deflationary flood is too specific. It is difficult enough to identify the most probable events for the next few years and any additional specific details quickly diminish the probability forecast is correct. Second, by saying there is a huge risk of second wave of credit concerns, Hussman basically admits that the current fiscal and monetary policy stance is appropriate for the next few years.

Third, the return of significant inflation means that the intrinsic value of MBS is near par again, and the real budgetary cost of bailouts is low. Fourth, at the first sign of increased inflation in the actual data FOMC hawks will be able to tighten monetary policy. Timothy Geithner's extended Fannie and Freddie funding commitment will allow Fed to shrink the monetary base without big pain. Fifth, fiscal hawks in the Congress will prevent the worst forms of fiscal incontinence.

Sixth, Hussman has repeatedly stated he thinks Fed's monetary policy has no effect, because higher fed funds rates have no effect because they pressure monetary velocity higher. This is just a classic case of confusing correlation with causation.

Don't get me wrong - I completely agree with Hussman that the current stimulus is of the wrong kind. It is just that any stimulus is better than none when the risk of deflationary spiral is still looming ahead. And I am also confident that Hussman will wait for very attractive entry points for commodity positions needed to hedge the inflation risks he sees.


  1. Would You explain, how inflation can lift the intrinsic value of mortgage backed securities?

  2. Yes, inflation lifts intrinsic nominal value of many things.

  3. Hussmann is wrong as his definition of money supply is too narrow. he needs to include credit creation i.e. the private sector method of creating money. If the public sector is increasing its portion of the money supply but the private sector is decreasing it at a faster rate then it will not be possible for inflation to take hold.

  4. @anonymous
    Hussman fears that the effect you mention will stop after a couple of years.


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