Friday, October 9, 2009

Fed update; money creation continues apace

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.


Comment2010 said...

So it seems TIPS are a fantastic investment right now?

Scott Grannis said...

Not exactly. TIPS are an excellent conservative investment vehicle. Probably better than cash for keeping money safe. Better than Treasuries. But ultimately their total return will be a function of inflation, and there is no telling right now how much higher inflation might be. TIPS would probably do better than stocks only in a very high inflation scenario (7-10% or more).

Charles said...

The monetary base has ceased to have any relation to the money supply since the fed now pays interest on reserves. The right way to look at this is that the fed is long on long-term treasuries, MBS and other debt instruments and short on federal funds.

Will they tighten when the time comes to do it? I think not. If they tighten quickly, equity markets will crash and the banks will fail.

Scott Grannis said...

Paying interest on reserves changes the dynamics of monetary policy, but it doesn't stop the banks from making new loans. If the expected return on the loan is greater than the fed funds rate, then banks will inevitably increase their lending, or at least attempt to.

W.E. Heasley said...

Mr. Grannis:

When Bernanke decides to withdraw, his options will surely be constrained. Political-Economy suggests that the constraint is partially embedded in the Political environment. Politicos wanted voted in, not out. Politicos do not peddle pain, they peddle spending.

The Economy aspect of Political-Economy is that Bernanke will be constrained by:

(1) the Fed unleashed unprecedented QE,

(2) the Progressives/Socialists unleashed the Spruce Goose of all Keynesian Deficit Government Spending,

(2a) you have unpresented QE simultaneously deployed with a huge sum of Keynesian Deficit Government Spending,

(3) both QE and Keynesian Deficit Government Spending were theories developed in environments of low or no existing Government Debt,

(4) this time around QE and Keynesian Deficit Government spending have been simultaneously deployed in an existing environment of Hyper-Debt. This is clearly not a low debt or surplus environment.

Hence when Bernanke finally bellies-up-to-the-bar, he may find there are only a handful of policy choices.

DaleW said...


I look at the forward breakeven rate curve on TIPS every day and the whole curve has shifted up over the last few weeks. It makes life a little easier as an equity investor to have a little monetary inflation and I think real demand and monetary velocity is growing in the economy (I pay attention to a number of transport indexes and like the Cass index best). So I am not worried at the moment, but I have definitely noticed the breakeven curve moving up.

Scott Grannis said...

I can't argue that you are wrong, because there are so many variables involved. I'll only say that disaster is not the only possible scenario, and it is possible to envision scenarios in which things work out more or less ok. Consider that with short-term interest rates and even T-bond yields basically at historically low levels, the market is willing to pay extremely high prices for securities such as the ones the Fed has been purchasing (Treasury, Agency and MBS). Therefore it shouldn't necessarily be too hard for the Fed to sell those securities. They are already exploring innovative ways to do that.

Also consider that Obama has encountered an awful lot of opposition to his Big Government agenda, and the elections next year promise to be quite exciting in their ability to change the direction of government policies.

Scott Grannis said...

Dale: Thanks for the pointer to the Cass index; looks interesting. Things are percolating all over the place, and that is good.

Public Library said...

The "tipping point" already occurred with the dollar. Global central banks and oil reserve countries are done playing the American game.

Our last bastion of competitive advantage was exporting financial wizardry. That is over and now the playing field is much more even in terms of technology, manufacturing, and policy. IN fact, we soon could find our country and a complete disadvantage.

You can talk about American ingenuity all day long but that fails to consider the ingenuity of other countries now that the barriers to entry hardly exist in the capitalism game.

We have an army but we are debt laden and armies will not dictate the future landscape anyway. Capital will and we are broke.

Besides, our army has failed in just about every war since the WW's.

Sell the buck-a-roo, bet on inflation and commodities, and look to other countries to drive the global economy forward with your investment.

The tipping point came and went in 2008. It is rarely as clear as the events that took place.

__ said...

"their total return will be a function of inflation"

If I recall correctly, TIPS accrue based on NSA CPI, meaning their return will be a function of a 'cost of living' index, not an inflation index.

Scott Grannis said...

MW: you are correct. I would argue however that the CPI (regardless of whether it is seasonally adjusted or not) is a good proxy for inflation over time. Indeed, several serious studies (most notably that done by the Boskin Commission in 1996) have concluded that the CPI actually tends to overstate inflation, and I agree. My working assumption is that the CPI overstates true inflation (as measured by either the PCE or GDP deflator) by about 0.5% per year on average. For TIPS investors, this is a very good thing.

__ said...

My concern about TIPS is that the govt has an incentive to cheat, and I have no doubt that if inflation gets to a high level (5%+?), that's exactly what they will do. I think Marc Faber's approach to predicting government behaviour was probably the right approach --- imagine the worst thing that can happen, then double it.

Scott Grannis said...

Governments have been known to cheat on the CPI (Argentina comes to mind), but for the US to do it would be a long shot in my mind. It would be really hard to get away with, in any event. Things have become so complex that it would be almost impossible to tinker with the CPI and not have anyone discover it.

But if it did come to that, then we would be in a world of hurt in so many ways that fudging the CPI would be a minor problem.

Public Library said...

You are presuming they aren't already under manipulation...

Scott Grannis said...

Those folks have been crying wolf for a long time. The problem is that their numbers just don't make sense; they don't fit with all the other numbers out there (e.g., the deflators). The gap between the actual CPI and their CPI over the past 20 years has got to be way over 100%. Their CPI looks to have been growing about 7% on average for the past 20 years, while the actual CPI has grown about 2.5%. Figure out the cumulative difference and you will see it is almost impossible for their number to be correct. How can the actual price level be more than double what the government says it is?

__ said...

There is a good rebuttal of ShadowStats on Econbrowser.