-- John Kemp is a Reuters columnist. The opinions expressed are his own --
By John Kemp
LONDON, Feb 3 (Reuters) - Perhaps the most significant development in financial markets over the last month has been the steepening of the yield curve for U.S. Treasury debt.
Like other indicators based on market expectations, the yield curve is not an infallible guide to the future. But the shift suggests investors are beginning to brace for higher inflation rates between 2010 and 2012, with rising commodity and energy prices likely to drive the increase.
Curve steepening represents a balance between intense demand for security and liquidity in the short term, matched by longer-term concerns about the cost of bank rescues and fiscal stimulus, and possible emergence of inflation as a result of all the liquidity being pumped into the banking system.
Investors are increasingly convinced liquidity will remain too high for too long, with the Fed hesitating to end emergency programmes until there are firm signs of recovery. Whisper it quietly, but there is also widespread suspicion the Fed would welcome a modest increase in inflation as one way to ease the burden of debts which built up during the late 1990s and early 2000s.
In recent weeks, officials have considered committing the central bank to an inflation target, but seem to have rejected the idea for now. One reason is probably that it would fuel suspicions about the central bank's willingness to tolerate faster inflation, pushing bond rates up just when the Fed wants them to come down. But the other is lack of agreement on what the target itself would be.
For fifteen years, central banks have defined their loosely worded "price stability" objective as an inflation rate of about two percent. But there is nothing special about this number either in economic theory or the operating statutes.
Most economists have expressed a preference for low but positive inflation. But there is no specific reason to prefer a rate of two percent rather than three percent or four percent.
Arguably, disinflationary forces in the late 1990s caused the major central banks to set inflation targets that were artificially low and over-ambitious. Policymakers and investors became obsessed by minute changes in the measured inflation rate (down to tenths of a percentage point), blinding them to mounting signs of instability elsewhere.
So the Fed and other central banks could probably tolerate an increase in inflation to three or even four percent in the medium term, and still label it "price stability", if it would help stabilise the banking system and promote a strong and sustained recovery.
A DISTANT MIRROR
It might seem odd to be writing about inflation and rising commodity prices amid the worst slump in the global economy since the 1930s. But past experience and economic theory both point to a sharp rise in inflation and commodity prices as part of a strong cyclical recovery during the three years from 2010 to 2012.
Popular perception of the Great Depression is one long unending slump lasting a decade from the stock market crash in 1929 and ending with outbreak of the Second World War. Nothing could be further from the truth.
While the whole decade was grim, the depression was actually two separate downturns (1929-33 and 1937-39), both deep, punctuated by one of the strongest cyclical upswings on record (1934-37).
This cyclical pattern (wrenching declines in output and prices, followed by equally spectacular recoveries) was fairly typical of the economy's cyclical behaviour before the rise of post-1945 Keynesian demand management.
The chart here (https://customers.reuters.com/d/graphics/CYCLE2.pdf) illustrates the deep cyclical swings that characterised the pre-war economy, with more detail on its behaviour during the 1930s here (https://customers.reuters.com/d/graphics/CYCLE3.pdf).
Between July 1929 and July 1933, manufacturing output in the United States declined at an average rate of 7.1 percent a year. Wholesale prices fell 6 percent. What seared the "Great Contraction" of 1929-1933 into popular consciousness was not the speed of decline but the fact it went on for four long years, seemingly unendingly, and culminated in the spectacular nationwide banking failures of early 1933, in which more than 8 percent of all U.S. bank deposits became frozen in suspended banks.
But once the economy stabilised in early 1933, a powerful cyclical recovery got underway. From July 1933 to the next peak in July 1937, output surged by an average of 9 percent a year, while wholesale prices rose 6 percent.
By the July 1937, wholesale prices had reversed about three quarters of their previous decline and were fast approaching levels that had prevailed at the end of the Roaring Twenties.
Crucially, reflation was driven by raw materials. Between 1933 and 1937, steel prices rose 40 percent. By 1937 billet was more expensive than before the crash. The price of copper halved between 1928 and 1933. But by 1937 it had risen almost 90 percent, and was fast approaching the pre-slump level.
Consumer prices rose half as fast (3.4 percent per year) as producer ones (6.4 percent per year). But the surge in steel, especially in 1936 and the first half of 1937, was enough to convince Fed officials policy needed to be tightened.
Senior officials were particularly worried rising materials prices would intersect with the large amount of excess liquidity in the banking system to fuel even further price increases in future. The Fed estimated U.S. banks were holding around $3 billion of potentially inflationary "excess reserves". So the central bank set out to drain the system, hiking reserve requirements three times in the space of less than a year, from 13 percent to 26 percent.
The direct result was previously excess reserves were "absorbed" and suddenly became required ones. The indirect one was a massive crippling contraction in credit. Subsequent observers have accused the Fed of killing the recovery, tipping the economy into a renewed and vicious recession from which it did not fully recover until the onset of war.
For a full discussion of the cyclical credit and commodity dynamics of the 1930s see the chartbook here (https://customers.reuters.com/d/graphics/DSTMIRROR.pdf).
Bernanke is unlikely to want to repeat the error. If commodity and energy prices begin a strong recovery in 2010-12, the Fed will almost certainly deflect calls to raise interest rates and withdraw excess liquidity, claiming it is a one-off realignment rather than ongoing inflation.
Experience in the 1930s as well as more recently, suggests the Fed will accommodate raw materials prices rather than risk ending the expansion prematurely. Liquidity conditions will remain highly favourable to commodity-driven reflation.
The full-impact of second round effects of the recession (as job losses and fear dampen consumer spending, and investment falls) have yet to be felt. But downturns do not last forever. The average business cycle contraction in the United States has lasted 17 months. Only one contraction in the modern era (1929-1933) lasted more than two years, and that was compounded by policy errors that led to the almost total evisceration of the banking system, which have not been repeated.
With the banking apparently stabilising, albeit on central bank life-support, and the current downturn starting in December 2007, it is reasonable to assume the cyclical trough will occur sometime in H2 2009.
Once activity has hit the trough, past experience suggests a powerful rebound, driven by the need to rebuild depleted inventory along the supply chain, and accompanied by a resurgence of raw materials prices.
While commodities are unlikely to regain frothy peaks recorded in the first half of this year, the normal recovery pattern makes it quite conceivable they will regain the relatively high levels reported in 2006 and 2007 (ie crude oil prices of $60-100 per barrel) by 2012-2013.
In a policy environment that will prioritise growth and jobs, the Fed could easily re-label an inflation rate of 3 or even 4 percent as consistent with stable prices, noting it is a recovery from a low base, and tighten only slowly, even as raw materials prices climb.