Friday, October 9, 2009
Despite Bernanke's hawkish rhetoric of late, the Fed continues to expand the monetary base, mainly by buying Treasuries, Agencies, and Mortgage-backed securities with newly-minted bank reserves. The Monetary Base (currency plus bank reserves), the part of the money supply that the Fed controls directly, now stands at an all-time high, exactly one year to the day after the Fed went into emergency/panic mode. Simply put, over the past year the Fed has doubled the supply of high-powered money that only it has the ability to create. To put this in perspective I can only say that if you went back in time and asked any and all prominent economists to assess the likelihood that the U.S. Federal Reserve would some day do such a thing (i.e., double the monetary base in the span of one year), I think there it would be virtually certain that all of them would have dismissed it outright. It was simply unthinkable; something that could occur only in a banana republic.
All this money creation (aka monetization of Treasury, Agency and MBS debt) has not yet created an inflationary firestorm because the Fed's has mainly been satisfying the banking system's incredible demand for money. The vast majority of the newly-created bank reserves remain on the Fed's balance sheet unused; banks feel more comfortable holding idle reserves at the Fed rather than using them to support new lending. As Milton Friedman taught us, inflation is a monetary phenomenon and it happens when the supply of money exceeds the demand for money. If the Fed supplies money that is demanded, that is not inflationary. The problem we all worry about is what will happen with the demand for money falls: will the Fed be quick to reverse course and shrink its supply of money to system?
While we're waiting to see if Bernanke is going to pull off the incredible feat of shrinking the money supply dramatically, or whether we are going to end up with an inflationary nightmare, I think it is worthwhile to consider the signposts on the margin. Disconcertingly, most of them seem to be saying that the demand for money is already beginning to weaken, albeit only mildly. These indicators are all measures of the balance between the supply of the demand for dollars: the dollar has fallen to within 5% or so of its all-time low against other major currencies, suggesting that there is a surplus of dollars in the world; gold has reached an all-time nominal high, suggesting that the world's investors are willing to bet that gold, which has a relatively finite supply, will perform better than the value of the dollar, which seems to have an almost infinite supply; the yield curve is very steep, which suggests that it is almost certain that the Fed will have to raise interest rates at some point to contain inflationary pressures; and commodity prices are very near their highs for the year, suggesting that global demand is strong and (presumably) speculative demand for commodities is strong (fueled by very cheap financing costs).
The one indicator which has yet to flash red is the breakeven spread on TIPS. TIPS continue to be priced to a benign inflation environment (i.e., 2-2.5%) in coming years. As I've explained previously, I'm willing to disregard this because I think there is plenty of evidence that the bond market is a poor predictor of inflation. T-bond yields chronically underestimated inflation in the 1970s, and they chronically overestimated inflation in the 1980s and 1990s. The bond market misses the inflation signals because it pays too much attention to what the Fed says, and the Fed's inflation track record is not exactly pristine: witness the real estate and commodity price bubbles of 2002-2006.
Posted by Scott Grannis at 10:55 PM