Sunday, May 16, 2010

The Complicated Inflation Outlook
Joe El Rady

With the economy seemingly rebounding, inflation worriers’ voices have grown louder with the familiar decrying of the massive money printing of the last couple of years. Indeed, the Federal Reserve has tremendously increased the monetary base. The chart below clearly visualizes the frightening increase.

However, before you start having nightmares that propel you stockpile ammunition and gold, you must remember two key issues. First, the Fed’s increase of the monetary base has only served to offset the decrease in money velocity. Okay, before we get too techie with our macroeconomics here, just remember (or learn for the first time) the simple equation that prices equal money times velocity (P = M * V). Simple math, this equation has two moving parts: money and velocity; and, any increase in one can be offset by a decrease in the other. The chart below clearly shows this offset, and should put you at ease (at least about inflation, but should scare the hell out of you about the economy.) Money velocity (think of it as usage) has decreased precipitously.

The fed is just trying to replace the lost circulation with volume. Net effect: zero—prices stay the same, no inflation! In fact, for a while, the rate of decrease of the velocity seemed to be greater than the rate of increase of the money, so we had some deflation.

The second issue to remember—and this is very important: the Monetary Base is NOT the money in circulation in the economy. In fact, the Fed doesn’t actually create new money out of thin air, as most people believe. The fed just circulates, recirculates and recycles money into and out of bank reserves. Banks can then lend a multiple of that money in their reserves (the inverse of their regulatory reserve ratio). That is how new money is created. Credit expansion by commercial banks creates new money, not the Fed! And right now, as the chart of the money multiplier clearly shows, no new money is being created because banks aren’t lending because they just have too many bad loans on their books against which they must hold capital in reserve (loan loss reserves).

So what happens when banks start lending again? Well, this will take a while. Banks simply need to clear the mountain of bad and questionable debt from their books. Secondly, even when their balance sheets recover, banks are likely to emerge with tougher internal and regulatory lending standards that will dampen the rate of credit expansion.

Nevertheless, the economy may eventually strengthen and banks may eventually lend more freely (I’m not convinced that the US economy has a very bright future, but more on that in a different post), and that may portend inflation in the long term. And this is where the story gets dangerous. Historically, the Fed has had a pretty easy time draining the liquidity it had placed into the market. This time may prove different. The Fed responded to the financial crisis by buying very low quality assets from financial institutions. Regardless of the long term worth or worthlessness of those assets, a market for them does not exist and isn’t likely to exist any time in the future. How is the Fed going to drain the liquidity it placed into the market when no one will want to buy the assets on its balance sheet? The Fed simply is not holding enough high quality assets to sell in order to remove money from the market. This, ultimately, is the real inflation worry we face (but in the long term, not now.)

Many inflation worriers have argued this point. They fear that the Fed simply does not have the monetary levers to drain the liquidity. And they are correct. Of course, the federal government can and probably should end up using fiscal policy to drain the liquidity. (Somehow people only ever focus on monetary policy and forget about fiscal policy.) As you may or may not have noticed, the federal debt has ballooned and our infrastructure is crumbling. These are generally recipes for poor economic growth. Fiscal discipline will eventually have to be imposed. Taxes will need to be increased and this would drain liquidity from the system. Sounds simple enough right? So why am I still concerned? Well, I simply don’t trust politicians to make the correct policy decision. I fear that they will simply do what they have always done, make whatever decision gets them re-elected—generally that means not increasing taxes. In lieu of higher taxes: we will face more debt and a devalued currency, which will lead to higher inflation.

A Federal Reserve without proper monetary solutions and a federal government without the will to implement the proper fiscal tools spell a recipe for long term higher inflation. And yes, I’m scared.