Tag Archives: quantitative easing

Inflation is a Monetary Phenomenon, But This Isn’t Inflation

There has been much talk recently about the potential inflation on the horizon given the unprecedented movement of the Federal Reserve of increasing the monetary base through quantitative easing. The talk has predominantly surrounded the substantial increase in the monetary base. However, increases in the monetary base are not sufficient to cause inflation. Like discussion of other markets, we must consider both supply and demand conditions.

Milton Friedman famously quipped, “inflation is always and everywhere a monetary phenomenon.” Friedman was undoubtedly correct. However, recently a few seem to have taken this claim to mean something different entirely. Namely, that any increase in the money supply necessarily causes inflation. This is something that Friedman himself did not believe.

In his restatement of the quantity theory of money, Friedman pointed out that the quantity theory is primarily a theory of money demand. Specifically, quantity theorists view the level of real money balances as more important than the nominal quantity of money. Thus, if at any point in time people have chosen to hold some level of real money balances that they deem optimal, an increase in the nominal money supply will leave these individuals with a larger level of real money balances than they wish to hold. These individuals will then necessarily try to reduce their holdings of nominal money balances such that their real money balances fall back to their optimal level (perhaps by increasing spending). Unfortunately, as a group, they will not be able to do so because every person’s spending is another person’s receipt (or income). Initially output will increase and gradually prices will rise until the level of real balances falls back to the optimal level.

Given this discussion, it should not be difficult to understand why I prefer a monetary equilibrium framework. What’s more, it should be apparent that what causes inflation is not an increase in the money supply, but rather an excess supply of money.

Ultimately, the question at hand is whether the current increases in the monetary base imply that there is an excess supply for money. If so, inflation is on the horizon. If not, we need not fear inflation.

Personally, I do not believe that the recent increases in base money imply that there is an excess supply of money. There are a couple reasons for this belief. First, it has been well-known — at least among monetarists — since Clark Warburton’s influential work that the peaks in the time series variables important for quantity theorists follow this order: (1) money, (2) output, and (3) velocity. The implication here is that declines in velocity (increases in the demand for money) are an accentuating feature of the business cycle. In other words, after output begins to fall, the demand for money increases. As our previous discussion of monetary equilibrium implies, this creates an excess demand for money, which results in falling output and prices — thereby exacerbating the previous decline in output.

Second, the money multiplier has declined drastically. In fact, the money multiplier for M1 remains below 1. This means that for every increase of $1 in base money, the money supply (as measured by M1) increases by less than $1. In order to determine the cause of the decline in the M1 multiplier, we should first discuss its components. The money multiplier for M1 consists of the currency-to-deposit ratio, the required reserve-to-deposit ratio, and the excess reserve-to-deposit ratio. An increase in any of these ratios implies that the money multiplier will fall. The required reserve ratio is set by the Federal Reserve and has not changed. Thus, the decline in the M1 multiplier must be the result of changes in the currency-to-deposit ratio and the excess reserve ratio. As previously mentioned, the demand for money often increases during the downturn in the business cycle. What’s more, financial crises often induce a flight to quality in which individuals abandon risky investments for safe investments such as bonds or cash. The increase in cash balances increases the currency-to-deposit ratio.

The largest cause of the decline in the money multiplier, however, is the result of the increase in the level of excess reserves. What’s more, this increase in excess reserves can be directly attributed to the fact that the Federal Reserve started paying interest on excess reserves late last year. In doing so, the Fed essentially reduced the opportunity cost of holding excess reserves thereby giving banks the incentive to hold more reserves on their balance sheets. This is why our friend Scott Sumner not only supports eliminating the interest payments on excess reserves, but prefers that the Fed impose a penalty on those who hold reserves above the required level.

Ultimately, the money multiplier (M1) has fallen from around 1.6 prior to the recession to .93 as of June 17. At the beginning of January 2008, the monetary base was roughly $848 billion. Given that money multiplier, this would suggest that M1 was around $1.356 trillion. Thus, given the current money multiplier, this would suggest that the monetary base would have to be about $1.458 trillion today to maintain the same money supply — an increase of roughly 72%. Given that we are currently in a recession, this suggests that the Fed wants to increase the money supply rather than simply maintain the earlier level. Given that the monetary base is about 90% higher than it was at this time last year, this would suggest that the Fed is expansionary, but hardly over-expansionary given the circumstances surrounding money demand.

With that being said, the Fed must be careful and begin pulling money out of the economy when this demand for base money subsides and the money multiplier begins to rise again. A failure to do so would result in a substantial period of inflation. However, at the current time, the evidence suggests that the massive increase in the monetary base is justified by the increase in the demand for base money. Thus, the increase is in the monetary base doesn’t suggest that massive inflation is on the horizon … yet.

(In the future, I hope to post on how the Fed can prevent finding itself in such a precarious situation in the future, but this is clearly enough for now.)

Should We Fear Rising Bond Yields?

There seems to be some concern as to the rising yields on long-term bonds. Our friend Jimmy P. (now of Reuters) quotes Scott Grannis, who writes:

The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an to keep their yields low is a self-defeating strategy … Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world’s demand to own bonds, and yields will rise. … So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise.

This presents two interesting questions:

1. Is the Fed trying to lower long-term rates?

2. Are rising long-term rates a bad thing?

I think that the answer to (1) is ‘no’. Counter to what seems to be the conventional wisdom, I believe that the Fed is buying long-term bonds because because short-term bonds and cash having largely been near perfect substitutes for quite some time. Thus replacing an asset that banks are gladly holding at near zero yield for an asset that earns zero yield isn’t likely to create the proper incentive to expand the money supply and stimulate economic activity. Buying the longer term debt, on the other hand, serves the purpose of creating the incentive to replace said debt with something that earns a return, thereby promoting lending and monetary expansion. What’s more this monetary expansion, if successful (or, more appropriately, credible) will begin to create an increase in inflation expectations, reduce the real interest, and therefore create demand for investment.

This latter point brings us to question number 2.

I similarly think that the answer to (2) is ‘no’ as well (or at least ‘not yet’). The creation of inflation expectations will temporarily lower the real interest rate, but as these expectations become more widespread the nominal interest rates will start to creep up. The recent increase in nominal rates is seen by some (including Scott Grannis, above) to be a sign that investors are worried about inflation. I am not convinced that this is the case for two reasons.

First, the nominal rates on bonds have been at historically low levels for some time. These low rates are largely the result of expectations of deflation and, more importantly, the flight to quality. Given this diagnosis, it is not surprising that these longer term bond yields have started to rise. Indeed, Martin Wolf (HT: David Beckworth) notes:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone.

The most important point to take away from this is that inflation expectations are in line with rates in which the Federal Reserve is quite comfortable. Thus, I am not trying to argue that rising inflation expectations have played no role in the rising bond yields, but rather than these increases are the result of a return to normal conditions (hence my reason for offering the qualification ‘not yet’).

The second reason that I remain unconcerned about the rising yields is that the phenomenon is not unique to the United States. One of the main points underlying the inflation expectation concerns is that the Federal Reserve will monetize some of the growing debt (or similarly about the risk of default). However, if increases in bond yields were the result of the growing budget deficit and debt, then one would expect to see such increases in the United States, but not countries with relatively small deficits. With that being said, Stephen Gordon’s recent comparison of the yields on Canadian and U.S. bonds throws a wet blanket on this hypothesis. He notes:

As we all know, Canada’s deficit and debt picture resembles in no way that of the US. But a US recovery is a sufficient (although perhaps not necessary) condition for a Canadian recovery.

If investors were suddenly concerned about default, it’s hard to see why Canadian bond yields should be affected in the same way that US yields would be. But if investors are anticipating a US recovery that would spill over to Canada, then we would expect long-term interest rates in both countries to increase.

Thus, like Gordon, I would argue that the rising yields are a good thing as they seem to indicate a return to normalcy rather than runaway inflation expectations. This is also a sign that the Fed’s policy of quantitative easing is working (at least in terms of what I believe to be the Fed’s goals).

Bernanke pushes the accelerator

From the FOMC statement:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of evolving financial and economic developments.

[Emphasis added.]