Dark clouds looming

A good piece from The Economist on “the dark clouds around the silver lining” of Fed monetary policy. A highlight:

…constraining the economy to so low a rate of average inflation is a good way to ensure that very low inflation or deflation becomes a serious threat whenever the next shock hits. That would be nasty in and of itself, given what we have learned about wage rigidity over the course of this business cycle. It is made all the worse by the very high probability that interest rates will quickly fall back to zero during the next downturn. That’s the third reason to pull one’s hair out over the Fed’s preferred approach: the lower the average inflation rate, the lower the nominal interest rate consistent with normal economic growth, and the higher the odds of hitting the zero lower bound whenever trouble strikes.

And the kicker:

…the Fed is the world’s monetary pacesetter, and it is rapidly moving toward tightening at a time when a disinflationary freeze is settling in around the rest of the globe. The Fed may tell itself that its responsibility is to take a very narrow, domestic view. Given the interconnectedness of the global financial system, taking a narrow, domestic view strikes me as a bad idea, even in terms of pure American self-interest.

I think this author is on to something important, but I don’t agree that the Fed is going to be as hawkish as he thinks. I don’t expect a rate hike in 2015 largely for those reasons this author cites. In short, I don’t think the Fed is “rapidly moving toward tightening” right now.

Russia is doomed

Breaking at Bloomberg: The Central Bank of Russia has raised its key interest rate from 10.5 to 17 percent. This hearkens back to a post I published on Friday regarding divergence among central banks with regard to monetary policy stance. Some face looming deflation (or at least disinflation), like the ECB and Bank of Japan. Others allegedly face inflation, like the Fed (though I’ve expressed my disillusionment with that theory in that same post I cite above). The Central Bank of Russia obviously falls into the latter camp.

Interestingly, the Central Bank of Russia cites existing sanctions on Russia in the first paragraph of its December Summary. Might this hint at more aggressive action to come on the part of Putin to remove these sanctions? The Summary also predicts -4.5% to -4.7% GDP growth in 2015 should oil prices remain at $60 per barrel through 2017. In short, disaster looms. A Washington Post headline tonight literally says “Russia’s economy is doomed.”

I’d like to research the interest rates moves that led up to this hike. I’d like to look for similarities with the Fed’s monetary stance—whether we can learn anything from Russia’s experience with monetary easing that applies in the U.S. I’ll do that tomorrow.

On a related note, that Summary is horribly written (or at least horribly translated). Can they not afford a professional?

Here’s nice summary of four economists’ in-their-own-words views on why inflation is so low despite five years of quantitative easing. I find Schiff unconvincing, Henderson refreshing, Sumner quite convincing, and Murphy wrong (disappointingly). Check it out and see if you can tell why.

QE over? Brace for inflation.

Lots of people began worrying about inflation when the Federal Reserve began QE back in 2008. Some even predicted “inflationary disaster,” warning that the monetary base cannot quintuple without a correlating rise in consumer prices.

For a while, I believed these guys. I was an undergraduate economics student at the time, and their logic made sense to me. Increasing the money supply will increase nominal prices, right?

Not quite. It’s true that increasing the supply of money will increase nominal prices, but QE didn’t increase the money supply, per se. It’s immediate effect is to increase the level of base money, which doesn’t change the supply of circulating money. What matters for price inflation, of course, is circulating money.

The reason we didn’t see the type of inflation these inflation-hawks warned about is because the new base money did not increase the M1 money stock (circulating money) like they predicted. They didn’t account for the Fed’s ability to control the rate at which this new money raises the M1 money stock via the interest it pays on base money accounts. And of course, the Fed has every incentive to keep inflation under control.

I’ve written about this before. When the Fed creates money, they don’t inject it into the economy with the intent that it has an immediate, proportional effect on consumer price levels. They deposit the new money into banks’ accounts at the Fed, where it collects interest. This has the effect of increasing bank reserves relative to the M1 money stock. It’s up to the banks, then, how they use these levels of reserves to increase lending activities and grow their balance sheets. By and large, banks have been quite conservative in this regard.

To put it simply, what these inflation-hawks should have been watching was not the amount of QE or growth in the monetary base, but the rate at which base money sparks more lending. That rate has been pretty low.

Now back to the title of this post…

The reason QE’s end should raise inflation fears is because, on the margin, banks will begin lending more to make up the difference from revenue lost because of QE’s end. For years, these banks’ reserve accounts at the Fed have been growing and earning interest. Now they’ve stopped growing (though they still earn interest).

Of course, banks don’t necessarily have to make up this difference. It’s just base money, and big banks aren’t anywhere close to being reserve-constrained. But as I said above, this tendency will happen on the margin. Not every bank will increase lending, but their incentives have now changed in favor of more lending and less hoarding.

I think the reason why we should fear inflation more now that QE is over is clear: Banks have less incentive to hoard cash in their Fed reserve accounts, as these accounts will now grow at a slower rate. The only way to make up this difference is to invest elsewhere. This will have the effect of turning base money into circulating money more often (technically, this is an increase in the M1 money multiplier, which we indeed saw every time QE ended in the past six years).

But prices respond to more than just changes in the money supply. These extra-monetary influences are likely to be stronger in the short-term—especially the appreciating dollar. So I’m not saying to brace for hyperinflation next month, or even any inflation next month. These things take time. Price inflation always lags behind monetary inflation. But I do predict that banks’ propensity to lend will increase, ceteris paribus. This type of inflation–not price fluctuations due to things like fluxing foreign demand, appreciating dollar, etc.–is what matters from a business cycle perspective, and what drives robust, sustained, real monetary inflation in the long term.

Rogoff on the exaggerated death of inflation

Harvard economist Kenneth Rogoff writing on the “exaggerated death” of inflation.

I am not arguing that inflation will return anytime soon in safe-haven economies such as the US or Japan. Though US labor markets are tightening, and the new Fed chair has emphatically emphasized the importance of maximum employment, there is still little risk of high inflation in the near future.

Still, over the longer run, there is no guarantee that any central bank will be able to hold the line in the face of adverse shocks such as continuing slow productivity growth, high debt levels, and pressure to reduce inequality through government transfers. The risk would be particularly high in the event of other major shocks – say, a general rise in global real interest rates.

Global inflation rates are far lower today, on average, than they were in the early 1990s. Rogoff credits this to “massive institutional improvements concerning central banks.” But such improvements, he says, aren’t enough to stave off inflationary forces should productivity continue to slow and commodity prices continue to rise like they did in the 1970s.

I think he’s right.

Truth on inflation, and some questions

Peter Klein speaks my mind on CPI. Namely, CPI doesn’t immediately reflect the malinvestment facilitated by artificial credit expansion because it measures inflation for “ordinary” consumer goods. It does not readily capture asset price inflation in things like equities, commodities, and agricultural land.

 

My question now, however: Is it feasible to differentiate artificially-induced asset price inflation from those variances we should expect to see as supply and demand for various assets changes over time? David Ranson, for example, famously argues that CPI understates inflation and that commodity prices should be used to more accurately gauge the extent of monetary inflation in the economy. He writes:

Market analysts usually attribute changes in the prices of commodities – uniform, widely traded goods, such as metals – to higher or lower demand in major world economies, such as the United States and China. However, the price of a commodity also relates to the value of the currency in which prices are expressed, in most cases the U.S. dollar.

But I’m skeptical. Simply saying that the price of a commodity “also relates to the value of the currency in which prices are expressed” doesn’t tell us anything if we don’t know the extent to which a commodity’s price shifts reflect changes in supply and demand (“fundamentals”) versus changes in the money stock. Ranson doesn’t really answer this problem in his analysis, yet he proceeds to use the rising price of gold to indicate monetary inflation.

Is the Fed Really to Blame?

bernankThis article was originally published at ValuesandCapitalism.com on August 14, 2012.

With the passage of Ron Paul’s “Audit the Fed” bill in the House recently, monetary policy is once again becoming a mainstream political issue. And it’s about time. For decades, Americans have stood idly by as inflation destroys the value of their hard-earned savings with the sole purpose of pushing economic problems further into the future.

But while Paul and many Republicans like to blame the Federal Reserve, the fact is that inflation has as much to do with your own personal spending habits as it does with Bernanke and his cohorts at the Fed.

According to the BEA, Americans saved an average of 3.9% of their income last May. Over the past several decades, this number has been steadily declining. Indeed, just 30 years ago, the personal savings rate was near 10%, meaning Americans saved almost three times more money than they do today.

While there are various explanations for this decline in personal savings, perhaps the most popular among conservatives is that reckless inflationary policies scare many would-be savers into spending more money to avoid higher prices in the future. Thus, the Fed and big government would be to blame, as only they have the power to legally create money out of thin air.

But another perspective on this decline—while less convenient—is equally plausible and decidedly more ominous. That is, Americans’ failure to save money left little reason for them to actively oppose the inflationary environment that government has always desired. Inflation, then, is a resultand not just a cause of Americans’ own personal financial irresponsibility.

For example, Americans who save a portion of their income every year have much to lose to inflation. Indeed, the more money they’ve put away in the past, the more loss they will experience as the Fed expands the money supply and devalues the dollar. Savings do not adjust for inflation.

On the other hand, Americans who do not save have virtually nothing to lose—they have no substantial wealth for inflation to diminish. Yes, their groceries might become more expensive. But wages adjust for inflation all the time, and inflation for spenders is simply nominal—very little happens to their levels of real wealth.

That said, as Americans continue to spend more and more, they will become increasingly less likely to vote against inflation, let alone actively oppose it. And the further they go into debt, the more an inflationary status quo will become desirable. Currently, levels of personal debt and spending in the US are so high that any serious attempt at curbing inflation through legislative means is probably unrealistic. The reality of inflation simply does not hit home for most Americans, despite the fact that its long-term consequences are disastrous.

Of course, Keynesian economists often welcome this increased spending. Too much saving, they argue, is an impediment to economic progress. But saving and investment are the true engines of economic growth, and without a private sector backed by financially sound individuals, sustainable progress over time will remain an economic fantasy.

No doubt, blaming “average Joes” for inflation isn’t as marketable as blaming Bernanke. But when Americans are saving less than four percent of their income, the effects of inflation become palatable—even attractive—to many Americans, and elected officials find the support they need to fund excessive spending with irresponsible inflation.

Congress and the Federal Reserve are not blameless, however. An audit of the Federal Reserve should have happened decades ago, and the ever-expanding government “safety net” discourages rainy day saving. But before you go marching on Washington, make sure your own financial house is in order.

As long as Americans continue to spend themselves into oblivion, inflation will continue to run its destructive course. We are a republic, indeed. Our elected officials must pass our test if they are to remain in power. Thus, as we seek to preserve capitalism, reexamining our own values and habits will be far more effective than blaming those to whom we ourselves give power. Indeed, how much we spend is ultimately up to us—a matter of personal responsibility.

In the end, Congressman Ron Paul puts it well:

We would like to think that all we have to do is elect the right politicians and everything is going to be OK. But the government is a reflection of the people and their values. That is why the burden is on people like you to make sure we have those values.

Read the rest at ValuesandCapitalism.com.

How You Contribute to Monetary Inflation

Inflation

A few weeks ago, I had the privilege of speaking to a small gathering of churchgoers about the causes, dangers and morality of monetary inflation—a topic about which I wrote recently. The audience was great and followed up the presentation with several thoughtful and challenging questions.

One in particular stood out: “Are there ways that we—well meaning, moral and informed people—unknowingly contribute to our nation’s culture of inflation and excess spending?”

It was a great question, and one I admittedly did not know how to answer at the time. But after some days of pondering, I have identified three ways in which even the most virtuous of us fuel our culture’s (and government’s) addiction to inflation.

First: Going into debt.

I don’t believe acquiring debt is always a bad decision. Given a particular circumstance, it may even be the most prudent choice. But debtors face a temptation to favor inflation that is difficult for even the most honorable of people to overcome.

The fact is, when money is debased through inflation, debtors gain the difference. If I borrow $10,000 tomorrow to fund a new car, I gain (at the expense of my creditor) from whatever debasement of the dollar occurs as I’m paying it back. If the dollar has lost five percent of its value by the time I start paying off the loan, I will be paying back five percent less in real terms.

That said, by going into debt, one exposes himself to moral hazard that too easily makes a principled opposition to excessive inflation take a back seat to the short-term gain that occurs in an inflationary environment. And when everyone is a debtor, preventing inflation via representative government becomes virtually impossible.

Second: Spending too much and saving too little.

Even if your personal finances remain in the black, spending too much as a percentage of your income lessens the harm that inflation has on your personal finances. This—like inflation—creates dangerous moral hazard.

For example, someone who spends 95 percent of his income each week has very little savings to actually be devalued in an inflationary environment. And assuming wages periodically adjust, inflation can be almost meaningless—he loses nothing. Price changes for him are strictly nominal and inflation does not affect his wealth.

On the other hand, someone who prudently saves 50 percent of his income each week stands to lose as the dollar is progressively devalued. What he put away in the past becomes worth less and less as inflation runs its course, making the accumulation of wealth over time exceedingly difficult.

Therefore, by spending too much money, one stands to lose very little from inflation, and in turn has little incentive to exert pressure on officials to refrain from inflating the money supply.

Third: Voting “single-issue.”

It is a known fact that most Americans vote for a candidate based on his or her belief on two or three particular issues. Taxes, spending, abortion … these issues make and break elections.

But monetary policy, while complex difficult to understand, is just as important as any other political issue. Voters should consider candidates monetary views when deciding who to support. Indeed, the nature of money as a universal medium of exchange means bad monetary policy harms everyone, and is thus a very important policy area. Bad money corrupts a rational economic order, and ignoring this issue when voting makes one as responsible for inflation as those who actively promote such policies.

Voters everywhere should keep their representatives accountable on the issue of monetary policy like they do on the other “mainstream” issues.

These are three ways in which well-meaning, informed people unknowingly contribute to our nation’s culture of excessive inflation. Consider yourself warned, however, and take measures to protect yourself from your own selfish heart.

Read the article at ValuesandCapitalism.com.