While inflation seems to be on everyone’s mind these days, misconceptions abound. Indeed, few concepts in economics are as misunderstood as inflation. This month I take a look at some common questions about inflation, and a few that I wish more people were asking.
Until we return to a stable, rule-bound international monetary system, inflation will continue to be source of anxiety in economies and asset markets around the world.
Is hyperinflation coming to the U.S.?
No. Hyperinflation arises only under the most extreme conditions,
such as war, political mismanagement, or the transition from a
command economy to a market-based economy. If you compare the U.S.
to countries that have experienced hyperinflation- think Iran,
North Korea, Zimbabwe, and the former Yugoslavia, for example
— the U.S. doesn’t even come close. Hyperinflation begins
when a country experiences an inflation rate of greater than 50%
percent per month — which comes out to about 13,000% per
year. Although it experienced elevated inflation around the time of
the Revolution and the Civil War, the United States has never
passed this magic mark. At present, the U.S. inflation rate,
measured by the consumer price index (CPI), is less than 2% per
year. So, to say that the U.S. is on its way to hyperinflation is
just nonsense.
But what about Quantitative Easing? Won’t that cause
high inflation?
No, at least not under the current QE program. What many people
fail to understand is that the money created by the Fed, through
programs like Quantitative Easing, is what’s known as “state money”
(monetary base). In the U.S., this makes up only 15% of the money
supply, broadly measured. The remainder is made up of “bank money”
— the allimportant portion of the money supply produced by
banks, through deposit creation.
So, while the Fed has more than tripled the supply of state money since the collapse of Lehman Brothers, in September 2008, this component of the money supply is still paltry compared to the total money supply. In fact, when measured broadly, using a Divisia M4 metric, the U.S. money supply is actually 6% below trend (see the accompanying chart).
There are a number of factors that affect the growth of money, but there are two main factors that have hamperedbroad money growth in the United States since the financial crisis. Not surprisingly, they are both government created.The first is the squeeze that has been put on the banks, as a result of Dodd-Frank and Basel III capital-asset ratio hikes. By requiring banks to hold more capital per dollar of assets (read: loans), the regulators have put a constraint on bank’s balance sheets, which limits their ability to lend. In consequence, money supply growth has been slower than it would have otherwise been.
The other factor is the credit crunch created by the Fed’s zero-interest-rate policy. This has dried up the interbank lending market, because banks have little financial incentive to lend to each other. Without a well-functioning interbank lending market to ensure balance sheet liquidity, banks have been unwilling to scale up or even retain their forward loan commitments.
The end result is a loose state money/tight bank money monetary mix. And since bank money makes up 85% of the total, the money supply in the U.S. is still, on balance, tight and below trend. That said, the broad Divisia M4 measure of the money supply has started to show signs of life in recent months.
How Can The Fed Avoid Inflation Going
Forward?
The Fed should start paying attention to the dollar. While
operating under a regime of inflation targeting and a floating U.S.
dollar exchange rate, Chairman Bernanke has seen fit to ignore
fluctuations in the value of the dollar. Indeed, changes in the
dollar’s exchange value do not appear as one of the six metrics on
“Bernanke’s Dashboard” — the one the chairman uses to gauge
the appropriateness of monetary policy. Perhaps this explains why
Bernanke has been dismissive of questions suggesting that changes
in the dollar’s exchange value influence either commodity prices or
more broad gauges of inflation.
The relationship between the dollar’s value and inflation has been abundantly clear for the last decade. As Nobelist Robert Mundell has convincingly argued, changes in exchange rates transmit inflation (or deflation) into economies, and they can do so rapidly. This relationship was particularly pronounced during the financial crisis (see the accompanying chart).
Indeed, from 2007-09, the monthly year-over-year percent changes in the consumer price index and in the USD/EUR exchange rate have a correlation of 0.75. As can be seen in the chart, there is a roughly two-month lag between changes in the USD/EUR exchange rate and in the CPI; when we factor in this lag, the correlation strengthens to 0.94.
By ignoring this, Bernanke was “flying blind” in the initial months of the crisis. In consequence, the Fed failed to stabilize the USD/EUR exchange rate, which swung dramatically in the months surrounding the collapse of Lehman Brothers.
Accordingly, the Fed acted too slowly in cutting the federal funds rate to stabilize inflation, which swung from an alarming rate of over 5% (year-over-year), to a negative (deflationary) rate in a matter of a few short months. If Bernanke had been monitoring the USD/EUR exchange rate, he would have realized that he was engaging in an ultra-tight monetary policy in the early months of the financial crisis. He would have known then to act much sooner than December 2008 — almost two months after the Lehman bankruptcy. Perhaps if he had tried to stabilize the value of the greenback, the bankruptcy may never have occurred in the first place.
How Does the Value of the Dollar Influence
Inflation?
One important way the dollar’s value affects inflation is through
commodity prices. With few exceptions, when the dollar weakens
against the euro, commodity prices soar, and when the dollar soars
against the euro, commodity prices plunge. As every commodity
trader knows, when the value of the dollar falls, the nominal
dollar prices of internationally traded commodities — like
gold, rice, corn and oil — must increase because more dollars
are required to purchase the same quantity of any commodity. The
linkage between the dollar-euro exchange rate and commodity prices
is depicted in the accompanying chart.
During the 2002-July 2008 period, the dollar declined steeply against the euro, and commodity prices surged. When the dollar subsequently rebounded, after Lehman Brothers collapsed, commodity prices tumbled. And again, following the first quarter of 2009, the renewed decline in the dollar’s exchange rate brought with it another surge in commodity prices.
We can see the consequences of this relationship in the lead-up to the 2008 financial crisis. During the five years preceding the Lehman Brothers’ collapse, the Fed’s favorite inflation target — the consumer price index, absent food and energy prices — was increasing at a regular, modest rate. But, this was an illusion. As can be seen in the accompanying chart, a weakening dollar drove up asset prices in the equities, commodities, and, of course, housing markets.
Unbeknownst to the Fed, abrupt shifts in major relative prices were underfoot. For example, housing prices — measured by the Case-Shiller home price index — were surging, increasing by 45% from the first quarter in 2003 until their peak in the first quarter of 2006. Share prices were also on a tear, increasing by 66% from the first quarter of 2003 until they peaked in the first quarter of 2008.
The most dramatic price increases were in the commodities, however. Measured by the Commodity Research Bureau’s spot index, commodity prices increased by 92% from the first quarter of 2003 to their pre-Lehman Brothers peak in the second quarter of 2008.
The dramatic jump in commodity prices was due, in large part, to the fact that a weak dollar accompanied the Fed’s ultra-low interest rates. Measured by the Federal Reserve’s Trade-Weighted Exchange Index for major currencies, the greenback fell in value by 30.5% from 2003 to mid-July 2008.
For any economist worth his salt, these relative price changes should have set off alarm bells. Unfortunately, the Fed’s CPI inflation metric signaled “no problems”.
How Does the Dollar’s Value Affect the Global
Economy?
The dollar has become a staple currency for the invoicing of
exports, and as a transaction currency in foreign exchange markets.
For example, Australia, Korea, Thailand, and Malaysia all have over
70% of their exports invoiced in dollars, even though only 25% of
their trade is with the United States. Indeed, in most countries,
the share of exports invoiced in dollars is larger than the share
of actual exports to the United Sates. Clearly, the dollar has
become the “vehicle” currency in international trade.
Thus, the dollar dominates the international markets. But, what does this mean when the value of the dollar fluctuates? Well, because of this “dollar standard”, producer prices around the world all move in the opposite direction of the value of the dollar (see the accompanying chart).
Indeed, since 2000, decreases in the value of the dollar have been clearly linked to increases in producer prices around the world. Given the recent loose talk of currency wars, it is little wonder that finance ministers in countries like China and Brazil are worried about a depreciating dollar affecting their producer prices, causing inflationary pressures.
That said, the United States can only expect to stay insulated from elevated inflation in emerging markets for so long. Indeed, while the U.S. money supply remains under trend, leaving inflation in check (for now), we may see inflationary pressures begin to surface before long. That is, unless the greenback continues to finds renewed strength — which has been evident in recent months.
What Can Be Done?
When it comes to exchange rates, stability might not be everything,
but everything is nothing without stability. The world’s two most
important currencies — the dollar and the euro —
should, via formal agreement, trade in a zone ($1.20 - $1.40 to the
euro, for example). The European Central Bank would be obliged to
maintain this zone of stability by defending a weak dollar (by
purchasing dollars). Likewise, the Fed would be obliged to defend a
weak euro (by purchasing euros).
The East Asian dollar bloc, which was torpedoed during the 2003 Dubai Summit, should be resurrected — with the yuan and other Asian currencies tightly linked to the greenback. As for other countries (Brazil and Venezuela, for example), they should adopt currency boards, linked to either the dollar or euro. Or, they could simply “dollarize”, by adopting a foreign currency (like the dollar, for example) as their own.
Until we return to a stable, rule-bound international monetary system, inflation will continue to be source of anxiety in economies and asset markets around the world.
