Tag: inflation

Do Inflation Expectations Drive Consumption?

After proponents of the Federal Reserve’s second round of quantitative easing (QE2) abandoned the argument that QE2 would spur growth by bringing down interest rates (only after rates increased), the new defense became “we intended for rates to go up all along, as a result of increased inflation expectations.”  Since few would argue for increased inflation, or expectations of such, as an end in itself, the claim was that increases in inflation expectations would drive households to consume more, which would in turn causes businesses to hire more, bringing down the unemployment rate.  But does this chain of reasoning withstand empirical scrutiny?

It turns out looking at the historical data on inflation expectations, as collected at the University of Michigan, that inflation expectations and household savings rates (the inverse of consumption rates) are positively correlated.  Now of course correlation doesn’t mean causality,but what the data suggest is that instead of consuming more when inflation expectations increase, households have actually saved more.  This positive correlation also holds for the second half of the data series, so it’s not simply the result of a downward trend in either inflation or savings.

To review, the latest argument for QE2:  increase inflation expectations, which is assumed to increase consumption, which is hoped to increase employment.  The problem I’ve had all along with this position is that the only thing we know for certain is the first part, QE2 would increase inflation expectations.  The hope that it would increase consumption and hence employment was just that:  hope.  Given the disconnect we’ve seen between consumption and unemployment over the past 18 months, the third link in that chain is also a weak one.   So what do we have at the end of the day:  certain costs with fairly speculative and uncertain benefits.  And here I was thinking that reckless speculation was the sole province of the private sector.

Economic Slack and Inflation

While listening to NPR this morning, I was subjected to yet another economist claiming that we cannot have inflation in an environment of such high economic slack.  Setting aside the fact that perhaps this economist missed the 1970s, this is a vital question to examine, because it is the foundation of so much of Bernanke and the Federal Reserve’s current thinking.  That is, the notion that inflation is always and everywhere the result of an over-heating, or excess demand, economy.

One of the measures commonly followed by the Fed, and others of the slack-restrains-inflation school, is the measure of capacity utilization rate.  Setting aside some of the problems with this measure, are increases in capacity utilization associated with increasing inflation, as would be suggested by the slack-restraint school?  It turns out not.  Since 1967, when the data series begins, the correlation between capacity utilization and inflation, as measured by the consumer price index (CPI), has been negative.  That is, as more and more industrial and economic resources have been brought into use, inflation has actually fallen, rather than risen (as would be predicted).  A negative correlation also implies that low or falling capacity utilization does not mean low inflation.

Now what is positively correlated with inflation is the growth in the money supply.   The chart below shows annual changes in both CPI and M2.  Even just eye-balling the chart, one can see the positive correlation, which also shows up under statistical analysis. 

Another question one often hears in today’s economic discussions is what would Milton Friedman say?  I won’t claim to be able to channel Milton (or anyone else), but I do think the empirical evidence continues to support the conclusion that inflation is always and everywhere a monetary phenomenon.

Is the Federal Reserve Heading Towards Insolvency?

A recent statement from the Shadow Financial Regulatory Committee, points out that both rounds of quantitative easing by the Federal Reserve have dramatically altered the maturity structure of the Fed’s balance sheet.  Normally the Fed conducts monetary policy using short-term Treasury bills, which allows the Fed to avoid most interest rate risk.  In loading up its balance sheet with long-dated Treasuries and mortgage-backed securities, the Fed has exposed itself to significant interest rate risk.

Recall that the yield, or interest rate, on a long term asset is inversely related to its price.  So if you’re holding a mortgage that yields 5% and rates go up to 6%, then the value of that mortgage falls below par.  The same holds for Treasury securities.  I think  it is a safe assumption that rates will be higher at some point in the future.  When they finally do rise, and if the Fed still maintains a large balance sheet of long-dated assets, those assets will suffer losses.

Of course the Fed is not subject to mark-to-market rules and can avoid admitting losses by holding these assets to maturity.  But if the Fed, at some point in the future, wants to fight inflation, the most obvious way of doing so would be to sell off assets from its balance sheet.  It is hard to see the Fed engaging in substantial open-market operations without using its long-dated assets.  But if it is to sell these assets, it will have to do so at a loss (once again, because of higher rates).

Now the Fed claims to have other avenues by which to tighten, besides open-market operations.  For instance, it can raise the interest rate on excess reserves.  But then this would further erode the value of assets on its balance sheet.  Not to mention that they have to find the money somewhere to pay these higher rates on reserves.

Ultimately the Fed can continue to pay its bills, not out of earnings from its balance sheet, but by electronically crediting the accounts of its vendors and employees, but that would also be inflationary.  The real danger, again pointed out by the Shadow Committee, is that the Fed may avoid raising rates in order to minimize the losses embedded in its balance sheet.  One of the very real dangers from QE1 and QE2 is that the Fed has exposed itself to potential losses that are correlated with any efforts to fight inflation, raising serious questions as to its willingness to fight inflation.

The ‘Consumer Spending’ Myth

Journalists talk endlessly these days about the need for more consumer spending to revive the economy, and for government programs to juice consumer spending. Economist Steven Horwitz takes on the assumption that spending is the key to economic activity:

One of the most pernicious and widespread economic fallacies is the belief that consumption is the key to a healthy economy.  We hear this idea all the time in the popular press and casual conversation, particularly during economic downturns.  People say things like, “Well, if folks would just start buying things again, the economy would pick up” or “If we could only get more money in the hands of consumers, we’d get out of this recession.”  This belief in the power of consumption is also what has guided much of economic policy in the last couple of years, with its endless stream of stimulus packages.

This belief is an inheritance of misguided Keynesian thinking. Production, not consumption, is the source of wealth.  If we want a healthy economy, we need to create the conditions under which producers can get on with the process of creating wealth for others to consume, and under which households and firms can engage in thesaving necessary to finance that production….

Putting more resources in the hands of consumers through a government stimulus package fails precisely because the wealth so transferred ultimately has to come from producers.  This is obvious when the spending is financed by taxation, but it’s equally true for deficit spending and inflation.  With deficit spending the wealth comes from producers’ purchases of government bonds.  With inflation it comes proportionately from holders of dollars (obtained through acts of production) whose purchasing power is weakened by the excess supply of money.  In neither case does government create wealth. Nor does consumption.  The new ability to consume still originates in prior acts of production.  If we want real stimulus, we need to free up producers by creating a more hospitable environment for production and not penalize the saving that finances them.

Is There an Inflation-Unemployment Trade-off?

Much of what drives the policy choices of Ben Bernanke and the Federal Reserve is a belief in the ability to trade higher inflation for lower unemployment, known within the economics profession as the “Phillips curve.”   But does this trade-off actually exist? 

While its true that many have found a negative correlation between inflation and unemployment prior to 1960, looking at U.S. data, this relationship appears to have broken down in the mid-1960s, just about the time policy-makers thought they could exploit it (Lucas critique anyone?).

It is hard, looking at the graph, which displays the annual change in consumer prices over the previous year and unemployment, to see much of a relationship.  In fact, since 1960, the correlation between changes in CPI and unemployment has been positive.  We have generally seen rising unemployment along with rising inflation.  Of course, one might be concerned that the stagflation of the 1970s is driving this result. But looking at the data since 1980, there still remains a positive correlation between inflation and unemployment.  While I am not arguing that inflation causes unemployment (after all, correlation is not causation), it should be clear from the data that there is not some exploitable trade-off that policymakers get to choose.

The Richmond Fed also has a great history of the Phillips curve that is well worth the read.  Perhaps Fed President Jeff Lacker should bring copies to the next FOMC meeting.

Will the Federal Reserve’s Easy-Money Policy Turn the United States into a Global Laughingstock?

Early in the Obama Administration, there was an amusing/embarrassing incident when Chinese students laughed at Treasury Secretary Geithner when he claimed the United States had a strong-dollar policy.

I suspect that even Geithner would be smart enough to avoid such a claim today, not after the Fed’s announcement (with the full support of the White House and Treasury) that it would flood the economy with $600 billion of hot money. Here’s what my colleague Alan Reynolds wrote in the Wall Street Journal about Bernanke’s policy.

Mr. Bernanke…believes (contrary to our past experience with stagflation) that inflation is no danger thanks to economic slack (high unemployment). He reasons that if people can nonetheless be persuaded to expect higher inflation, regardless of the slack, that means interest rates will appear even lower in real terms. If that worked as planned, lower real interest rates would supposedly fix our hangover from the last Fed-financed borrowing binge by encouraging more borrowing. This whole scheme raises nagging questions. Why would domestic investors accept a lower yield on bonds if they expect higher inflation? And why would foreign investors accept a lower yield on U.S. bonds if they expect exchange rate losses on dollar-denominated securities? Why wouldn’t intelligent people shift their investments toward commodities or related stocks (such as mining and related machinery) and either shun, or sell short, long-term Treasurys? And if they did that, how could it possibly help the economy?

The rest of the world seems to share these concerns. The Germans are not big fans of America’s binge of borrowing and easy money. Here’s what Finance Minister Wolfgang Schäuble had to say in a recent interview.

The American growth model, on the other hand, is in a deep crisis. The United States lived on borrowed money for too long, inflating its financial sector unnecessarily and neglecting its small and mid-sized industrial companies. …I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don’t recognize the economic argument behind this measure. …The Fed’s decisions bring more uncertainty to the global economy. …It’s inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money.

The comment about borrowed money has a bit of hypocrisy since German government debt is not much lower than it is in the United States, but the Finance Minister surely is correct about monetary policy. And speaking of China, we now have the odd situation of a Chinese rating agency downgrading U.S. government debt.

The United States has lost its double-A credit rating with Dagong Global Credit Rating Co., Ltd., the first domestic rating agency in China, due to its new round of quantitative easing policy. Dagong Global on Tuesday downgraded the local and foreign currency long-term sovereign credit rating of the US by one level to A+ from previous AA with “negative” outlook.

This development shold be taken with a giant grain of salt, as explained by a Wall Street Journal blogger. Nonetheless, the fact that the China-based agency thought this was a smart tactic must say something about how the rest of the world is beginning to perceive America.

Simply stated, Obama is following Jimmy Carter-style economic policy, so nobody should be surprised if the result is 1970s-style stagflation.

Currency Wars Also Have Unintended Consequences and Collateral Damage

The Fed’s planned purchases of $600 billion of long-term Treasury bonds were targeted for domestic problems, but are having international consequences. The expansion of the Fed’s balance sheet drives down the foreign-exchange value of the U.S. dollar, and (same thing) forces other currencies to appreciate in value.

Emerging markets with high short-term interest rates will attract “hot money” flows. These flows are not stable sources of funding, and disrupt the small capital markets in these countries. Long-term, the appreciation of their currencies harms their competitiveness in global goods’ markets.

Brazil has already imposed capital controls and other emerging markets may follow. The Chinese in particular have reacted sharply.  According to a Reuters dispatch, Xia Bin, adviser to China’s central bank, said another financial crisis is “inevitable.” He added that China will act in its own interests.

In short, the Fed’s actions have undone whatever good came out of the G20 meetings. Any hope for cooperation on currency values and financial stability is out the window. There are potential spillovers in other areas of global cooperation.

Currency wars, like other wars, have unintended consequences and collateral damage.  Some countries will predictably react by imposing capital controls.  Moves to curb imports can follow. Monetary protectionism leads to trade protectionism.

However it might like matters to be, the Fed cannot simply act domestically.  It has reached the useful limits of further easing.