More money, less stuff to buy because of the pandemic should equal higher prices as those dollars chase stuff to buy, right?
Well... that is exactly what the Fed hopes will happen. It hasn't happened yet because the "velocity of money" (how quickly money gets spent again after it is received) fell off a cliff, as people went into lockdown, lost their jobs, and try to make whatever money they have last until things get back to normal. Money is being shoveled into the system... and is piling up as bank reserves:
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| That trillion dollar spike at the end is March and April. |
Here is my incomplete mental model of how the money creation machine works; for example, for a 'helicopter drop' :
Congress decides everybody gets $1,200. The US Treasury gets the dollars by trading promises to pay the money back in the future (treasury bonds). Who is lending their hard-earned dollars to the US government in exchange for a really low interest rate? Mostly it is the Federal Reserve, "lending" brand new dollars created out of thin air:
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| 4 trillion in March, April, May |
Normally the bank turns around and lends out most of those dollars so they can be spent again (increasing monetary velocity) but right now they are piling up as 'excess reserves'. The Fed pays 0.1% interest on reserves; I dunno why, I guess to make bankers even richer than they already are? (That's a cheap shot on my part; if inflation is 0.3%, they're actually losing 0.2% a year on those reserves). Banks could lend it all out; the reserve requirement was dropped to zero percent, which seems insane to me but I'm a programmer and not a monetary expert.
So inflation is low right now. Probably. It is hard to measure accurately in normal times, but really hard right now because everything changed in mid-March. People suddenly stopped buying bowling shoes and started buying a lot more face masks, so the typical 'basket of goods' economists use to measure price inflation suddenly isn't actually what the typical person is buying.
But what happens when we conquer (or learn to live with) the virus and people spend more and banks go back to lending? Will we get super high inflation then?
I dunno. The Fed can slow down bank lending by requiring them to hold more reserves. Although I gather a lot of lending is happening in the "shadow banking system" which doesn't have reserve requirements, so maybe that would just move a lot of activity out of traditional banks.
If inflation ramps up the Fed could directly drain trillions of dollars out of the system by selling the "securities held outright"-- mostly Treasury bonds, with some mortgage-backed securities leftover from the 2008 financial crisis. That is 6 trillion dollars at current market prices.
Higher inflation means the price of those low-interest-rate securities has to go down, and selling them will even further depress the price. Somebody smarter than me has probably estimated how many dollars the Fed can actually destroy by trading all that stuff (and making the dollars they get disappear), but maybe those trillions won't be enough to keep inflation in check.
Higher inflation, plus the Fed selling all those old Treasury Bonds at a discount should mean the Treasury will have to offer higher interest rates on new bonds, meaning more of the budget goes to paying interest on the debt.
Which politicians won't like. Maybe the Feds lose their minds, bow to political pressure and keep buying bonds, "sterilizing" the debt, leading to more inflation (and eventually hyperinflation if the cycle isn't broken). I don't think that is likely to happen in the US, but I'm a programmer, not a monetary expert. I'm hedging my bets and keeping my wealth mostly in inflation-immune assets, like bowling shoes and hand sanitizer.
Great article.
ReplyDeleteQuestion about this ...
"If inflation ramps up the Fed could directly drain trillions of dollars out of the system by selling the "securities held outright"-- mostly Treasury bonds, with some mortgage-backed securities leftover from the 2008 financial crisis."
Who do you think they'll end up selling this stuff to though? I can't imagine those MBS are assets anyone would want to hold. Which is why the FED bought it up in the first place, right?
I think it would be really hard for the Fed to sell those mortgage-backed securities right now-- a lot of people are having a hard time paying their mortgages.
ReplyDeleteBut inflation is low. If the economy comes back, so should the market for MBS-- assuming they have any value at all and all the underlying mortgages haven't all defaulted already.
Printing money not necessarily comes with inflation. It won’t if it offsets falling credit and the deflationary forces are balanced with this reflationary force. A dollar of spending paid for with money has the same effect on prices as a dollar of spending paid for with credit. Additionally, some part of the newly created money will go to innovation and hence, create a bubble. At some point the tipping point will occur and the end of the hyper cycle will follow.
ReplyDeleteGavin, I'd highly suggest following George Selgin on twitter (https://twitter.com/GeorgeSelgin). He makes the point that its not the 0.1% IOER rate that really matters. It's the *signal* the Fed is sending to the market. Selgin correctly points out that the 0.1% is a petty move that (more importantly) signals that the Fed will raise IOER in the future. If a commercial bank knows that IOER will be raised in the near future, it has no incentive to lend out reserves now, because they know these reserves are not like a hot potato.
ReplyDeleteIf Fed truly wants to make reserves like a hot potato and get banks lending again, they need to promise that in the future, IOER will be significantly *below* the 3 month or 10 year treasury yield. Right now the Fed is basically saying that IOER will equal the 3 month treasury yield...forever. No surprise banks don't lend out reserves
I talk about it more below (see Selgin podcast talk by clicking through)
https://twitter.com/SplitRockMgmt/status/1244011558306537473
Lyuboslav: I think you have a different way of thinking about all this than I do. Every credit is also a debit, so when thinking about inflation I think more about where the money is coming from, how quickly it is moving around, and where it is ending up. I don't distinguish between money used to pay off loans versus paying for broccoli (I care more about what the banker or the farmer do with the money when they get it).
ReplyDeleteJim: the 0.1% being a signal makes sense, and I completely agree they should drop it to zero. Or maybe negative....
Debt defaults could exceed these new debts, lowering M2, causing deflation.
ReplyDeleteDebt defaults against banks? I think I see how that decreases the money supply indirectly (less money created because of less bank lending), but if you owe me $100 then default on that debt (because you spent that $100 on something and can’t pay me back) I don’t think that affects the money supply at all.
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ReplyDeleteGavin, the Fed does not have to sell bonds to reduce the number of dollars in circulation. As the Fed's bond holdings mature, the Treasury repays principal to the Fed, removing money from circulation.
ReplyDeleteThroughout 2018, the Fed did reduce its balance sheet in this manner (more precisely, via partial reinvestment). You can see this in your plot of the Fed's balance sheet above.
Where does the Treasury get the money to repay the Fed? It could come from additional Treasury borrowing, in which case there is pressure for yields to rise. That is what happened in 2018. But in principle it can also come from an improved fiscal balance that can come with a stronger economy.
Sure, the Treasury can pay back old bonds with either tax money or money from new bonds. This blog post is about what might happen if inflation gets up above the 4% target rate, and the Fed decides it needs to quickly drain money out of the system.
DeleteYes, I'm making a point about how money is removed from the system. The point is that the Fed never has to sell bonds at all in order to drain money from the system. When bonds mature, the money is removed without the Fed ever selling a bond.
DeleteFor example, $2.5 trillion of the Fed's Treasury bonds mature within 5 years, so by doing nothing the Fed could drain about 10% of the money from the system each year.
While waiting for the money to be drained as bonds mature, they could disincentivize lending by banks and shadow banks, which would reduce available credit and bring inflation down.