Friday, October 2, 2009

No shortage of money (14)

Another update in a very long-running theme. This chart shows the latest data on bank reserves, which are the high-powered money that the Fed creates and which banks can use to expand their lending (and thus expand the amount of money in circulation). Many worry about the day when the Fed starts to reverse its liquidity injections, but that is tomorrow's problem. What we have today, after one year of the most incredibly aggressive monetary policy that would ever have been conceivable, is that bank reserves are TEN TIMES higher than they were just before the Lehman collapse last year.

The Fed remains fully committed to ensuring that there is no shortage of money in the system, and thus very little risk of deflation. Yet I continue to see many respected pundits and investors worrying about deflation. I continue to think their fears are misplaced.

The only way to really know whether there is an excess or a shortage of money is to look at market-based indicators of the value of money, such as the value of the dollar vis a vis other currencies and against gold and commodities, the slope of the yield curve, swap and credit spreads, and breakeven spreads. With the sole exception of breakeven spreads, all the other indicators say that we have a relative abundance of money in the system. TIPS spreads are merely saying that inflation is going to be a little below average in the years to come, and thus one might infer that the Fed is only a tiny bit less accommodative than it has been in years past.


Vespasianus said...

I agree the point now is not deflation, but the opposite. So far, it seems to me that liquidity effect is overcoming the future expectations of inflation, but it is a matter of time that this reverses, and interest rates rise, even under this scenario of money growth.


DaleW said...

So far, it seems to me that liquidity effect is overcoming the future expectations of inflation, but it is a matter of time that this reverses,

I am not so sure, having recently read The Lords of Finance. During the Depression, central bank governors were haunted by the specter of Weimar inflation and thus were overly restrictive for large portions of the Depression or went restrictive around 1936-1937 (as we saw in the US). I don't believe inflation is a matter of time. It's a matter of the reserves turning into money supply and money supply growing faster than real GDP, which is not at all predestined at this point.

Cabodog said...

The money doesn't seem to be finding its way to Main Street.

Bill said...

The trouble is banks are clearly not lending this money out to your average consumer with credit lines being slashed and loans much harder to get. It is sort of a chicken and egg problem: do the banks lend and help create an expansion or do they wait for an expansion to lend (which might be delayed because of restricted lending).

Scott Grannis said...

Think of it this way, though it's only small consolation: banks may not be lending money as freely as they used to, but our government is handing out money more freely than ever, thanks to the "stimulus" program.

What the government is borrowing to fund its stimulus spending is essentially equal to the money that the private sector is. This is how deficits "crowd out" private sector borrowing.

The money hasn't disappeared, but it is flowing through channels that are probably much less efficient than they were previously.

Comment2010 said...

It seems inflation protected bond yields compared to ordinary bond yields are predicting 2% inflation for the next 10 years. (Is there a way for me to upload charts to these comments?) Given stimulus spending by ALL other countries I cannot imagine a scenario that devalues the dollar against anything but commodities. My tilt toward deflation has been met by a suggestion that I overvalue the lack of demand. However, I have other reasons to fear deflation over inflation and the bond spread is just a second reason (beside the reason that the dollar cannot be devalued against other currencies.)

Comment2010 said...

Demand is a third reason and there are others. But I would like to stay focused on Bond spreads for this discussion.

Scott Grannis said...

I've made a series of posts on the subject of TIPS and breakeven inflation expectations. One recent one here

explains how I think it is that inflation risk is rising but TIPS don't show any signs of being concerned about inflation.

In short, I note that the bond market has never done a good job of predicting inflation. It is heavily influenced by what the Fed says and does, and the Fed has made a lot of mistakes too over the years.

I've also made numerous posts on the subject of the Phillips Curve theory of inflation (which puts huge emphasis on demand). Although it is a very popular theory, I have never seen evidence that proves it works. Indeed, the Fed's reliance on Phillips Curve thinking led them to be way too tight in the late 1990s, and way too easy in the 2002-2005 period, and we are still paying the price for those mistakes.

mojakus said...

The Fed's Flow of Funds accounts shows that the US shouldn't be concerned about a shortage of money supply, but rather a shortage of money demand. Debt outstanding is roughly flat, despite a huge increase in Treasury issuance to fund stimulus spending. Individuals and companies are in balance-sheet repair mode.

In any case, excess reserves are part of the monetary base, and are not in and of themselves monetary supply. Their level says nothing about monetary conditions without looking at the multiplier as well.

Certainly agree with your comments on TIPS - the bond market has a very poor track record predicting CPI. Not to mention predicting CPI adjusted for problems/errors like OER.