These are complicated times, especially when it comes to inflation.
An excess of debt, both private and public, has retarded the spending stream, resulting in sluggish economic growth. Given the Fed’s legislated commitment to prevent financial implosion and unemployment, rounds of central bank monetary responses have followed. The intuition of more money in our pockets chasing a limited supply of goods, as well as our long intellectual history of monetarism, sets off the reflex that printing results in inflation. That hasn’t appreciably happened yet, but multiple rounds of QE keep markets on edge given the teaching of Milton Friedman,
To add to the inflation paradox, last January, for the first time, the Fed committed to producing moderate inflation (2 percent) “over the long run“. However, as recently reported by David Rosenberg, inflation at the producer level was flat over the last quarter, and given the Euro recession and continued U.S. sluggishness, it appears likely that the inflation goal might not be reached. Indeed, many credible sources are forecasting long-run deflation, a la the trend in Japan.
On top of that there is the conjecture, mentioned in a recent post that in the (likely) event of an uncontrolled government deficit, the role of the central bank would be to generate actual inflation that exceeds the expected inflation premium that had been priced into interest rates. The purpose would be to reduce the real cost of government debt. This seems to suggest that the long-term Fed inflation target is to keep expectations anchored at a number the Fed hopes to exceed.
But in the longer run, while accumulating four decades of baby boomer entitlement debt, it would take one surprise after another to exceed expected and priced inflation. And each would have to be larger than the last to continuously have actual inflation exceed that which is priced by the market. This is the implied path to what is journalistically called “runaway inflation.”
The Fed inflation targeting in the long run is one thing, but the real question is whether the Fed can deliver when it so far has not.
The paradox of strong growth in the monetary base without the inflation implied by monetarism first surfaced when the first Federal Reserve balance sheet leap occurred in 2008. At the time, many people believed that a doubling of central bank money chasing a short term fixed supply of goods would bring about a doubling of the price level.
Obviously, that didn’t happen. The question is why not.
First off, at that time, the commercial banking system did not have the requisite regulatory solvency (an excess of asset values relative to deposits) to expand balance sheets if they had the risk tolerance. That is, today’s excess cash reserves of $1.5 trillion held by banks and a commercial bank money supply multiplier of say 10 would normally result in $15 trillion of lending and spending. A surge in bank-financed spending could roughly double the present $15 trillion annual flow rate of GDP and, with it, inflation.
The predicted proportionality of prices to money didn’t occur, as spending not only failed to increase appreciably with more central bank base money, but fell short of the economy’s supply potential so that deflationary forces from excess capacity still exist today. (This same phenomena to monetarists would be the explanation for the decline in the velocity of money.)
So the issue of inflation depends to a large extent on the ability and willingness of commercial banks to run with the base money given to them. The most recent reading of that is not encouraging to either the growth of spending or inflation, as the graph above shows.
Despite having been given a stealth capital buildup via an essential zero cost of funding program (in addition to the TARP subsidy), the commercial bank books claim solvency, but lending contracted in the first quarter. The Keynesian notion of the liquidity trap is still alive and festering with banks pointing to a lack of borrowers and borrowers pointing to a lack of willing lenders. The problem, more than loan risk analytics, is likely behavioral. As aptly discussed by Kevin Flynn:
“For the last 50 years banks have been behaving the same way — turning a profitable sector into a credit fad and then drowning it in the name of market share, management bonuses, takeover avoidance, or whatever. Once they blow a sector up, nobody wants to hear about lending to it again for another generation of CEO management, which runs for about five to 10 years (the last thing that managers brought in to replace disgraced managers want to do is more of what got their predecessors sacked). Banks finally got around to blowing up housing, so now we have a generation of bank executives in place whose unifying feature is the determination to avoid a housing bust that won’t happen again for another 70 years or so. The Fed can’t do anything about it.”
Given these impediments to produce monetary expansion and lending through banks, there are other routes by which the Fed might reach its inflation objective. Without bank follow-through, the impact of monetary expansion is limited to the Fed’s first round of financial purchasing power. This limitation of its firepower is what turned the Fed to large scale QEs, since there would be no commercial bank follow–through: They had to do the job themselves. But since the Fed is not a commercial lender, it mainly relies on what is known as a Pigou effect — a generalized market value of wealth spreading from bonds to equities and other assets that in turn induces limited spending but not at a rate sufficient to create inflation.
Another approach to inflation (which the Fed scoffs at) is un-lovingly called helicopter money. This was the first thing done when the financial meltdown occurred, in the form of the Fed putting money more directly into the hands of spenders (as opposed to financial asset markets). That is, rather than just continuing more of the same Fed expansion, helicopter money delivers fresh spending power directly to the end user (the consumer) over the heads of the moribund banks.
Believe it or not, this was implemented in the dark days of 2008, when the Fed purchased Treasury bonds that enabled the Treasury department to mail out an equal amount of government green checks directly to spenders. It flew under the radar screen as the checks were called tax rebates, and few knew the source of the funding. However, a wider distribution of government green checks coming from the Fed or the Treasury would require a more obvious money gift that would create contentious comparisons of need. To further rule out more green checks to consumers (especially voters), the Republican Party platform is now at odds with at grossly expansionary Fed tendencies, and the Fed is not likely to expose itself to legislative constrains to its independence.
If the government wishes to depreciate its debt and consumer debt with inflation, a more likely inflation alternative would be for the Treasury Department to turn to treasury currency, the United States Note. As previously explained, the government used this tactic to pay its bills during the Civil War.
In this case, the financing of government spending is facilitated by Treasury currency printing rather than Federal Reserve printing. Treasury currency would have a greater inflationary impact as it directly finances spending in goods markets. In this case, inflation would be a fiscal byproduct rather than a central bank contrivance.
Treasury currency would be more effective as it goes over the heads of the blocked banking system and reluctant spending units, and on behalf of the taxpayers, goes directly into the spending stream when the government pays for entitlements such as Medicare. As such it is a kind of super-helicopter money delivered to the goods markets rather than the financial markets or even to the consumer to be used for debt reduction as the new currency is injected into the spending and income stream.
When political leaders are pressed to “do something,” it seems that this would be the “something” that could simultaneously finance entitlement spending, reduce the size of the fiscal cliff, and reach a desired inflation target. This is a something for nothing policy solution that politicians who take the path of least resistance would find difficult to ignore–and it’s in the law.
What an irony. Despite the accusations being made, the Fed in these circumstances is only able to produce inflation expectations whereas Fed generated inflation is dependent upon a generational replacement of commercial bankers.
It seems the notion of an inflationary future one way or another is still alive and ticking. Recently, inflation adjusting assets including energy pipelines, gold, income producing real estate and infrastructure are now moving up in the markets and fixed income assets are moving downward. Though the Fed has struck out on the inflation front, the bet has switched at least at the margin to the government doing “something” in the long run to ultimately reach an inflation target. Keep tuned to see how these improbable policies and events work out.
If you enjoy this blog, please forward it to others who may be interested. Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!
Sign up to receive the Spellman Report.
Bracing financial and economic insight.
Now with free delivery!