There has been a great deal of talk regarding deflation recently. Today, Nouriel Roubini predicted that deflation will be the main concern of policy makers in the next six months. James Hamilton disagrees. Nevertheless, the drastic fall in housing prices and the recent crash in the money multiplier warrant a closer look.
At the onset of the Great Depression, the Fed was already in contractionary mode. The subsequent banking failures of 1930 – 1933 caused a flight to cash as many removed their money from banks. This flight to cash resulted in a severe monetary contraction as money moved from banks to mattresses (or so the saying goes). This monetary contraction led to the worst deflation in U.S. history with percentage price declines in the double digits. Now we have talked about irrational fears of deflation before, however, when deflation is the result of an excess demand for money, the effects can be quite disastrous.
The recent discussion regarding deflation begs the question as to whether we are currently in the midst of a monetary contraction.
On the supply-side, we are clearly not in a contractionary environment. However, as our friend David Beckworth points out, the money multiplier of the monetary base has declined substantially since June. Beckworth (as well as Hamilton) attribute this decline to the fact that the Fed is now paying interest on excess reserves. While Beckworth’s accompanying graph provides ample evidence that bank reserves have drastically increased, a closer look at the data suggests that the spike in reserves began in August (two months after the decline began in the money multiplier).
I draw two conclusions from the previous analysis. First, we are entering (or have entered) a contractionary monetary environment. Keynes’s theory of the liquidity preference is proving as poignant as ever as individuals are fleeing the stock market and other investments for the security of cash. Second, foreclosures are squeezing bank balance sheets and counter-party risk remains elevated (as is continually evident from the LIBOR-OIS spread). Given that the Fed is introducing new facilities each day to ensure that it has to tools necessary to combat the crisis, this implies that cautious banks are simply building excess reserves (and the Fed is now rewarding them for doing so). The result is a massive reduction in the money multiplier.
Thus far, the Fed has been very responsive. The reduction in the money multiplier has been met by a significant increase in the monetary base. So long as the Fed remains proactive, I am prepared to agree with James Hamilton that deflation is not on the horizon.