Tuesday, July 29, 2014
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When Inflation Doves Cry

PITTSBURGH – The Wall Street Journal recently ran a front-page article reporting that the monetary-policy “doves,” who had forecast low inflation in the United States, have gotten the better of the “hawks,” who argued that the Fed’s monthly purchases of long-term securities, or so-called quantitative easing (QE), would unleash faster price growth. The report was correct but misleading, for it failed to mention why there is so little inflation in the US today. Were the doves right, or just lucky?

The US Federal Reserve Board has pumped out trillions of dollars of reserves, but never have so many reserves produced so little monetary growth. Neither the hawks nor the doves (nor anyone else) expected that.

Monetarists insist that economies experience inflation when money-supply growth persistently exceeds output growth. That has not happened yet, so inflation has been postponed.

Instead of rejecting monetary theory and history, the army of Wall Street soothsayers should look beyond the Fed’s press releases and ask themselves: Does it make sense to throw out centuries of experience? Are we really so confident that the Fed has found a new way?

The Fed has printed new bank reserves with reckless abandon. But almost all of the reserves sit idle on commercial banks’ balance sheets. For the 12 months ending in July, the St. Louis Fed reports that bank reserves rose 31%. During the same period, a commonly used measure of monetary growth, M2, increased by only 6.8%. No sound monetarist thinks those numbers predict current inflation.

Indeed, almost all the reserves added in the second and third rounds of QE, more than 95%, are sitting in excess reserves, neither lent nor borrowed and never used to increase money in circulation. The Fed pays the banks 0.25% to keep them idle.

With $2 trillion in excess reserves, and the prospect of as much as $85 billion added each month, banks receive $5 billion a year, and rising, without taking any risk. For the bankers, that’s a bonanza, paid from monies that the Fed would normally pay to the US Treasury. And, adding insult to injury, about half the payment goes to branches of foreign banks.

In normal times, there are valid reasons for paying interest on excess reserves. Currently, however, it is downright counter-productive. Bank loans have started to increase, but small borrowers, new borrowers, and start-up companies are regularly refused.

Current low interest rates do not cover the risk that banks would take. To be sure, they could raise the rate for new and small borrowers; but, in the current political climate, they would stand accused of stifling economic recovery if they did.

The new Consumer Financial Protection Board is also a deterrent, as banks consider it safer to lend to the government, large corporations, and giant real-estate speculators. The banks can report record profits without much risk, rebuild capital, and pay dividends and bonuses. And the Fed can congratulate itself on the mostly unobserved way that the large banks have used taxpayers’ money.

Instead of continuing along this futile path, the Fed should end its open-ended QE3 now. It should stop paying interest on excess reserves until the US economy returns to a more normal footing. Most important, it should announce a strategy for eliminating the massive volume of such reserves.

I am puzzled, and frankly appalled, by the Fed’s failure to explain how it will restore its balance sheet to a non-inflationary level. The announcements to date simply increase uncertainty without telling the public anything useful. Selling $2 trillion of reserves will take years. It must do more than repeat that the Fed can raise interest rates paid on reserves to encourage banks to hold them. It will take a clearly stated, widely understood strategy – the kind that Paul Volcker introduced in 1979-1982 – to complete the job.

Should the end of QE come in September, December, or later? Does it matter? Historically, the Fed has typically been slow to respond to inflation. Waiting until inflation is here, as some propose, is the usual way. But that merely fuels inflation expectations and makes the task more painful.

And how high will the Fed push up interest rates? Once rates get to 5% or 6%, assuming inflation remains dormant, the Fed can expect a backlash from Congress, the administration, unions, homebuilders, and others.

When contemplating the consequences of this, remember that 40% of US government debt comes due within two years. Rolling it over at higher rates of 4% or 5% would add more than $100 billion to the budget deficit. And that is just the first two years. The budget cost increases every year, as more of the debt rolls over – and that does not include agency debt and the large increase in the current-account deficit to pay China, Japan, and other foreign holders of US debt.

Those who believe that inflation will remain low should look more thoroughly and think more clearly. There are plenty of good textbooks that explain what too many policymakers and financial-market participants would rather forget.

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  1. CommentedChee-Heong Quah

    To add, while M2 in the US has not increased much, that in the rest of the world has risen remarkably, especially in the BRICS countries. The reason is simple. The reserves created by the Fed found their way to the banking systems across the world and inflate their economies. Why? Because the dollar is still the international currency today.

    Hopefully, the Chinese yuan would hinder the dollar one day.

  2. CommentedF. W. Croft

    QE pushes down inflation but raises overall economic volatility/risk since it encourages mis-pricing of debt. When poorly-priced debt is re-priced following tapering (or when badly-priced securities default at higher-than-priced rates) a lot of investors are going to get hurt by QE.

  3. CommentedFrank O'Callaghan

    The huge QE and low inflation point out that a lot of what is talked about is not a description of what happens in the real economy. Much of the debate is to obscure the reality. There will be inflation and real chaos with default. The timing is the key. The poor, the powerless and the ignorant will be hurt. The great examples are Ireland, Greece and Iberia.

  4. CommentedG. A. Pakela

    Recent history suggests that inflation is not a monetary phenomena. It is a mass psychology which relies on credit expansion to propel it forward. The previous commentor has it exactly right - there can be no credit expansion when borrowers do not have the financial wherewithal to add yet more debt. That is not to say that the expansion of the monetary base will not eventually leak out into the economy and result in inflation. And, Dr. Meltzer is correct in identifying an alternate explanation for why the Fed's policies have actually stifled growth.

    It is ironic that the QE programs have been justified by Fed "doves" as countercyclical with the objective to return to full employment. It is hard to see how giving free cash to banks and making available below market, low interest loans to the most creditworthy borrowers has anything to do with job creation. If any policy is "trickle down" economics, current Fed policy is it!

  5. CommentedTim Chambers

    There is inflation occurring Dr. Melzter. Just look at the prices of stocks and bonds, driven by QE. For wage/price inflation to occur there need to be a few more variables in play. Like increased demand, increased velocity of money and increased competition for workers that drives up wages. None of those are occurring because so few people have disposable income that isn't isn't devoted to paying down debt. Moreover, so few people have decent jobs that that it will be many years before we see a jobseekers job market.

    The economic growth we sustained for the past forty years was mostly the effect of a credit bubble, not only in housing, but consumer credit. Until the deleveraging process is completed there won't be any wage/price inflation or economic growth. We are in a vicious circle sir, which can only result in more deflation. It is what results from permitting rent seekers to hoover up all the wealth in the economy through the tax system, the banking system, the privatization of government services, and globalization. The only thing that is going to save us is a debt holiday that wipes out the rentiers, and allows people to start spending again. But, if they are wise, they will pay in cash.

  6. CommentedJoshua Ioji Konov

    All it is about low Inflation comes up to Glo0balization and Rising Productivity of so called exogenous macro factors...

  7. CommentedDanny Cooper

    You need to create monetary stimulus that bypasses the banks. The fed needs to be modified so that it deals directly with the public so that the banks cant block stimulus or misdirect it into whatever activities they choose.

  8. CommentedJohn Doe

    banks are not making loans because someone would object about the rates being too high--again, we need an editor to save our time

  9. Portrait of Christopher T. Mahoney

    CommentedChristopher T. Mahoney

    As the author observes, QE is not leaking into M2, and M2 growth is too low. QE has no impact on money, so ending QE makes sense, as does ending IOR. But the real challenge is to get M2 growth to a level that creates higher inflation. I am beginning to think that a better policy than QE would be 100% deficit monetization until we get 2-3% sustained inflation. Instead of pumping liquidity into stagnant banks, why not get it directly into the economy via the federal deficit?

  10. CommentedStamatis Kavvadias

    The author is not thinking clearly. The FED is not depriving money from the treasury, because reserves are not money broadly circulated. He is right to say that the overnight interest rate is a subsidy. The banks have toxic assets and need to recover them, before they start lending as usual, to avoid loss of their capital in shares. Assuming that the subsidy will eventually end up in US budget is not really reasonable. It will probably remain in the FED's balance sheet perpetually, as happened after WWII. The FED will not bury US government under the cost of the recovery, unless it wants a revolution!

    The banks are very smart about lending, and do so only in paths that can lead to exports: as long as the refueling of the "money supply" is counterbalanced by dollar depreciation, there will be no inflation, and QE means dollar depreciation. For inflation to accrue, some of the money turned to financial gambling and large corporations, needs to overflow in the domestic economy, ending up in people that have reasonable expectations of repaying their private debts. For this to happen, the gains must be more than that of servicing bank debt, which means the banks can turn to such assets to continue their recovery. At that point, the FED will have to withdraw the QE and raise interest rates, and it will still have other ways to prevent banks from excessive lending in the short term (e.g. prudential regulations).

    That's all! Do not panic. The only problem is that the path is slow and painful for the 99%. The FED and the banks are betting on US strong companies. The only possible problem is that, when inflation starts to pick up, capital invested in foreign markets will start coming back to the US, but still in the financial markets, which can further increase the trickle down scenario, significantly increasing inflation (though it can also help US bonds). To the extend QE has been directed to non-banks, this can be a problem that cannot be handled by prudential regulations...

  11. CommentedJose araujo

    How many times do you have to announce the end of the world before it becomes obvious that you are WRONG. I know its painfull to recognize a long life of dedicated believes to go to waste, but c'mmon you are now just being patetic. Armagedeon days are not comming...

    The question to your doubts is just obvious, you just don't wan't to believe how simple it is. IF or better When we get out of this scenario, and risk aversion ends, savings and reserves are going to be mobilized into investment, fueling demand, growth and new investments. Since we are far from full employment no inflation is going to being generated.

      CommentedJohn McDonald

      Mr. Araujo's view is exactly the same as what blinded so many people leading up to the financial crisis in 2008, i.e., "nothing has gone wrong yet, so you must be wrong".
      He must be too young to remember the 70's, and not aware of what has happened more recently in other countries.