Forgive me; it has been six months since my last confession…oops I mean posting.
Since April all major investment markets have rallied. This is true of both stock and bond markets. Much of the rally is due to the coordinated policies of central bankers, especially the US Federal Reserve. Toxic assets (TARP, TALF) were purchased from commercial banks and insurance companies dramatically reducing risks, visible and hidden, of commercial bank asset bases. The twin policies of de-risking and improving disclosure provided the needed incentive for those investors looking for a reason to buy. A return to risks assumed has been re-established across the globe. Few would argue with the assessment that these efforts have resulted in the desired policy outcome of bringing order and stability to a global financial system that was unable to function in the last half of 2008.
The mandate of the Federal Reserve Bank is to use monetary policy to promote “maximum employment, stable prices and moderate long term interest rates.” Money supply is the major lever the Federal Reserve has to control the negative effects of inflation. This past year saw a unique policy response by the Fed. The unorthodox monetary policy that ensued presents many challenges today and especially in the future timing of unwinding the current position. The question remains: Will high levels of inflation result from the measures implemented by the Federal Reserve in 2008-09?
Money is created by the Fed in two ways: directly and indirectly. In the direct route, the government can print it or mint it. This is sometimes referred to as central bank money and includes net money assets of the government. This money is backed by market confidence in the ability of the issuer to meet its obligation through future tax revenues.
The indirect method is creating money through a fractional reserves system. The Federal Reserve controls the reserve of capital commercial banks are required to maintain in their operation. Today, Commercial Banks must deposit 10% of their assets in a reserve account with the Fed. From the perspective of the commercial lender, they can lend up to 10 times their asset base. This leverage creates money in the economy. This is commercial bank money also known as check book money.
Money supply has several definitions. For our purposes I will define Money supply as MB or monetary base which includes currency in circulation and demand deposits, minimum reserves and excess reserves held by the central bank.
The Fed enters into open market operations buying and selling t-bills, notes and bonds to principal dealers. The effect of a sale of bills or notes is to reduce the money supply by retiring money back to the fed. Alternatively, the when the Fed buys notes (or other assets) money supply increases. These operations also reduce or increase the leverage available further affecting the overall money supply.
Prior to October of 2008, increases in bank reserves ended up as currency in circulation. However in the fall of 2008 the fed began paying interest on excess reserves providing incentive for commercial banks to leave the money on deposit and out of circulation. This rate is equal to the upper limit of the fed funds rate of 25 basis points. The result is the increase in monetary base has had little impact on currency in circulation but has resulted in a dramatic increase in the Feds excess reserves account. This account increased from about 2 billion in mid 2008 to more than 750 billion in June of 2009.
University of Chicago economist Milton Friedman and others observed a long term relationship between money supply and inflation: (The quantity theory of money)
MV = PY
Where;
M= quantity of money
V = velocity of circulation
P = price level
Y = level of output of the economy
Friedman and other monetarists pointed out that change in money supply control the level of nominal output of the economy. Furthermore, in the long run, changes in money supply determine changes in prices or inflation. For Friedman “inflation is always and everywhere a monetary phenomenon, in that it can be produced only in a more rapid increase in the quantity of money than in output”.[1]
Inflation erodes purchasing power. This is how it affects the average family. For the US market, in the past 15 years the purchasing power of a US dollar has dropped to 67 cents. So a consumer needs fifty percent more dollars to buy the same basket of goods. Consumer Price Index (CPI) is the common measure of inflation along with the Core CPI which excludes the prices of food and energy. In the past 50 years the average annual change in CPI has been 4.2%, 4.1% for Core CPI. There has been a big range of values for CPI; greater than 14% in 1980 and -1.2% in June of 2009 (deflation). The Fed is believed to have a target for inflation of 2%. The Bank of Canada has an explicit target of 1-3% for Core CPI.
In July of 2008, prior to the default by Lehman Brothers in October of that year, US inflation levels were relatively high at 5.4%. US money supply was about 850 billion and had been stable at that level for several quarters. By June of 2009 CPI was -1.2% and money supply had doubled to more than 1.6 trillion dollars. In addition, through large scale purchases of agency debt and mortgage backed securities, the Federal Reserves assets base increased from about 900 billion to more than 2 trillion, though this was done in such a way as to avoid increasing money supply. The Federal Reserve funded the purchase of toxic assets through a special t-bill issued by the US Treasury. The deposit accounts of the Treasury are not part of the monetary base.
The challenge for the Federal Reserve is to shrink their balance sheet and reduce the money supply before inflationary expectations rise above their target. Moving too early will delay the economic recovery. Waiting too long will result in inflation. The incentives line up behind waiting too long.
Paying interest on reserves is a temporary solution. In the long run it adds to the monetary base. As well, commercial banks will find more profitable alternatives for the money. This is a big problem. 750 billion in the hands of commercial banks can result in as much as 7 trillion in additions to the money base.
Some options for the Fed to curb future inflation – exit strategy
1. The fed could use its powers to limit the leverage for commercial banks.
2. They can enter into reverse repurchase agreements (REPO) with commercial banks for the toxic assets on the feds balance sheet. If commercial banks enter into these agreements the monetary base will decrease through a reduction in the excess reserves account.
3. Treasury could issue debt and deposit the proceeds with the Fed.
4. Fed could issue its own debt directly reducing the monetary base, in competition with the Treasury.
5. Fed could let assets mature, or sell them into the markets.
Finally, the fed must be able to conduct monetary policy independent of political pressure. To avoid inflation there must be a shift from propping up credit institutions to one of price stability and oh yes they must get the timing very right.
We should probably get ready for inflation.
[1]
Milton Freidman, “The Counter—Revolution in Monetary theory,” Wincott Memorial Lecture, Institute for Economic Affairs, London, 1970.
