Wednesday, April 1, 2009

Some random thoughts on inflation (deflation)

I was in Mexico for one week and the only news-related materials I had were two March issues of the Economist; and fortunately, this is poolside reading for me. Anyway, the March 19th edition had a nice article about quantitative easing and the associated inflation angst and featured this chart to the left. The article inspired me to think a little more about why the Fed is taking such extreme balance sheet risk: inflation.

Recently, the Federal Open Market Committee shocked markets by announcing its intent to buy Treasuries in excess of the nominal 0.25% federal funds target, and to increase the MBS and agency coupon purchases by $850 billion. In spite of a 0.2% annual inflation rate in February, recent Fed policies like these have sparked fears of inflation, even hyperinflation. From the Economist:
On March 18th America’s inflation rate was reported at 0.2%, year on year, in February. The same day the Fed said “inflation could persist for a time” at uncomfortably low levels. Yet some economists and investors insist high inflation, even hyperinflation, is lurking in the wings. They have two sources of concern. The first is motive: the world is deleveraging, ie, trying to reduce the ratio of its debts to income. Policymakers might secretly prefer to do that through higher inflation, which lifts nominal incomes, than through the painful processes of cutting spending and retiring debt, or default. The second is captured by the Fed’s announcement that it plans to purchase $300 billion in Treasury bonds and an additional $850 billion of mortgage-related debt, bringing such purchases to $1.75 trillion in total, all paid for by printing money.
The Fed is doing what it is doing - quantitative easing - in an attempt to restore functionality to credit markets and to accommodate a low and falling money multiplier in order to secure price stability. Banks are hoarding funds (excess reserve balances one year ago were $1.8 billion and $771.2 billion now), which has been exacerbated by the Fed's paying interest on reserves, but nevertheless, reserves are surging. The result has been a collapse in the money multiplier, which disrupts the process by which the Fed's monetary policy measures (adding base to the system) are turned into money.

The chart above shows that the money multiplier has stabilized, but rests at very low levels. This is the bear faced by the Fed, and the primary reason for its extreme measures of late.

But contemporaneously, inflation expectations have taken a likewise turn for the worse. As falling inflation expectations become embedded into current behaviors (buying decisions or interest rate setting), the macroeconomy suffers. When oil was peaking in July of last year, the Fed watched inflation expectations closely for signs of pressure. And now, the Fed is watching those same expectations on the way down.

The chart illustrates market inflation expectations for each year over the next 10 years, as measured by the nominal 10-yr Treasury minus its inflation protected counterpart (TIPS). Admittedly, inflation expectations have improved significantly from their 0.04% low in November 2008 to 1.34% at the end of March. However, the market still expects just 1.34% annual inflation over the next 10 years, which is far below the Fed's new quasi inflation target of 1.7%-2.0%, and obviously a big concern.

This is why the Fed and central banks around the world are building up their balance sheets: inflation (deflation) risk. In the U.S. and according to the Taylor Rule, a nominal interest rate target based on current inflation, inflation expectations, and the output gap, the Fed should cut the federal funds target, the Fed's short-term interest rate to induce monetary stimulus, to -8%. Since that is impossible (a zero lower bound), the Fed is doing everything it can to support price stability.

Given the Fed's optimal scenario, a functioning credit market, it is very capable of taking back the added liquidity; and furthermore, I presume that the paying interest on reserve balances is part of the Fed's exit strategy. However, we will know in a year or two if the Fed gets it right. But know this: a $2 trillion balance sheet is just the beginning.

Rebecca Wilder


  1. Welcome back Rebecca. Hopefully your mind is well charged for the rest of 2009.

    The rate of growth in CPI (.2%) is not the the "inflation rate".

    That's the Consumer Price INDEX (CPI) net growth rate.

    The Inflation Rate is the rate of growth in new consumer and commercial credit owing to the money multiplier.

    When you inflate something, you blow it up, you expand it, you billow it, you make it bigger.

    It's a purposeful act.

    The idea behind Central Banking is monopoly control of manufacture of money and credit by controlling the price to rent now-money paid for with future-money.

    Central Bankers seek to INFLATE, to EXPAND the economy by cheapening the price of money for rent.

    Neither you nor anyone else is going to get and come to know how the economy works, what is the Science of Economics until you get this fundamental aspect of Central Banking.

    The CPI does not measure inflation.

    The CPI is a bogus index that purports to measure a single monolithic price for all goods sold in America. This is impossible, the stuff of fiction.

    When credit growth resumes, coupled with the recent growth of money (notes, coins), in the absence of inventory owing to our just-in-time world, commodity prices shall rise first, followed by prices of finished goods.

    It's unlikely that credit growth resumes until interest rates rise, (1) causing bankers to believe they could profit from loans through any future even if future rates fell a bit; and (2) causing cash seekers to believe they must rent cash now before rates rise further.

    Bernanke's 0 to 0.25% interbank lending rate (Fed Funds rate) is useless if bankers do not take advantage of the spread between that rate to rent cash and the street rate to sell cash.

    Bernanke's dumb decision to pay interest on reserves proves to be a major block to return to growth.

    At the start of the recession (August to October 2007), instead of cutting rates, Bernanke should have (1) raised reserve requirements (2) held interest rates steady.

    Instead, Bernanke cut rates until cash and Treasuries became equivalents.

    The acts of Bernanke have both deepened and lengthened the recession/depression of 2007 to 2009 plus.

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  3. Hi Smack,

    Good to hear that you are still obsessed with inflation and Bernanke!

    Thanks for visiting.

    Rebecca (had to delete my previous comment b/c I mistyped my name on account of the splint that I am wearing on one of my fingers - first time surfing).

  4. What? A splint! I feel for you Rebecca, ouch!

    Better that you have a mere splint on your finger than a cast on your leg!

    How's that for a sunny side look on life?

  5. Did the doctor-to-be put on the splint? Glad you are back and, hopefully refreshed. How do you like the goings-on at the G20 already. When the participants say in advance they want substantive agreements and not the vague wording of past years, things are looking up. Will be interesting to see how it affects the market.


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