Friday, April 20, 2012

By special request, here's a discussion of monetary policy and the economy.  For the last several years, some have warned that inflation will spin out of control because of QE1, QE2, and other forms of stimulus implemented by the Fed.  The basis for their argument is that the money supply is growing too rapidly and too much money is chasing too few goods, which results in high inflation.  So why hasn't inflation risen much above 3% in recent years?  One reason is that some are confusing the monetary base (which consists of bank reserves and cash in circulation) with the money supply (bank deposits and cash circulation).  The monetary base has experienced explosive growth since 2008, but the money supply hasn't grown nearly as much.  Since the collapse of Lehman Brothers in mid-Septmber, 2008, the monetary base has grown at an annual rate of 37%, but the money supply has only grown by 4.5% per year (though that has risen recently).  Why?  Because banks are holding onto a record amount of excess reserves (S1.5 trillion as of April 18, 2012).  Next, is there a chase taking place?  Going back to Irving Fisher, economists have made use of the equation of exchange to estimate this chase by multiplying the money supply (M) by the velocity of money (V).  How has this behaved over time?  The chart below estimates the chase by considering the percentage change in MV:


You'll note that it grew rapidly in the 1970s, resulting in inflation (as expected).  However, it dropped significantly during the recession and is still growing only modestly, thus suggesting that inflation is not a threat at this time.

What happens when banks start lending those excess reserves? Excess reserves declined by $100 billion in the second half of 2011, but have since stabilized.  If banks start loaning large amount of excess reserves, the money supply will begin to expand rapidly and inflation becomes a threat.  That's why it's critical for the Fed to have an exit strategy (which Ben Bernanke has explained on repeated occasions; for example, click here).  Having a strategy and executing it well is easier said than done.  In the mid-2000s, the Japanese central bank implemented QE and then withdrew it without igniting inflation, so it can be done.  On the flip side, how likely is QE3?  Bernanke has stressed that the primary rational for QE1, QE2, and a possible QE3 is to avoid deflation.  A sluggish recovery with moderate inflation doesn't justify QE3.  Barring another perceived (or actual) threat of deflation, QE3 would seem to be unlikely.

What's happening with bank lending?  Here's a table that traces bank lending in its many forms.  Commercial and industrial loans rebounded nicely in 2011, but real estate and consumer loans continue to languish.

The principles of monetary policy that existed prior to the Great Recession still appear to hold true.  Given that the money supply is not expanding at a rapid rate by historical standards and given that there's no chase, inflation is not a threat in the near term.  If conditions change and the Fed sits idly by, inflation could be an issue down the road, but this is unlikely to occur.  Executing the exit strategy will be difficult (too soon could stifle the recovery, too late could lead to higher inflation than desired), but chances are the mistake is likely to be relatively small, making high inflaiton unlikely.  On a related not, break-even inflation according to the TIPS market is 1.91% over the next 5 years and 2.19% over the next decade, suggesting that financial markets are not concerned about inflation any time soon.