Monday, October 15, 2012

The Reluctant Recovery: Part 2

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the second in a series (see the first here). In this second part, the main focus is monetary policy. I argue that the Fed has correctly responded to the huge increase in the demand for safe-haven dollar liquidity that was caused by the Great Recession and the Eurozone debt crisis. However, the measures they have taken are so unprecedented and so potentially inflationary that they have introduced a significant amount of uncertainty to the market, and this in turn has contributed to the market being reluctant to believe that the current recovery is sustainable.

Quantitative easing has been accomplished so far by the Fed purchasing $1.6 trillion of Treasuries and MBS, in three stages. QE3 has only recently begun, and it is still relatively modest in size, with purchases scheduled to be about $40 billion per month. These purchases have been paid for not with cash, but with bank reserves. Since the Fed decided to pay interest on bank reserves early on in the quantitative easing process, bank reserves are functionally equivalent to T-bills since they are almost as risk-free and yield a little more (currently the Fed pays 0.25% on reserves, which is a bit more than the 0.09% yield on 3-mo. T-bills). This is very different from how things worked in the past, when reserves paid no interest and banks therefore had a strong incentive to use additional reserves to expand lending. In effect, the Fed has swapped $1.6 trillion of T-bill equivalents for $1.6 trillion of notes and bonds. The Fed has not "printed money" in massive quantities as so many have been led to believe. The Fed has merely supplied an asset to the market that was in very high demand (i.e., T-bill equivalents whose price was so high they yielded almost nothing) in exchange for an asset that was in less demand (i.e., notes and bonds with lower prices and higher yields). 

Quantitative easing was necessary to accommodate increased money demand. When analyzing monetary policy, it is critical to establish whether the Fed's willingness to supply money is greater, lesser, or equal to the world's demand for money. If money supply exceeds money demand, the result is inflation (e.g., too much money chasing too few goods and services). If money supply is less than money demand, the result is deflation (e.g., a shortage of money relative to goods and services). If supply and demand are in balance, the result is monetary nirvana—low and stable inflation. As the chart above shows, the demand for money (M2 is the best proxy for "money" that I am aware of, and comparing M2 to GDP is a good way to see how much money people want to hold relative to their incomes and their spending) skyrocketed beginning with the collapse of Lehman Bros. in late 2008. In effect, the world's demand for money soared; people wanted to save more, spend less, increase their cash balances, and reduce their debt.

In the chart above, the increase in the ratio of M2 to GDP from September '08 through today is the equivalent of approximately $1.5 trillion in additional M2 growth. It is not a coincidence that the world's extra demand for money, sparked by fears of a global financial collapse and/or a global economic meltdown, was of the same order of magnitude as the Fed's injection of $1.6 trillion of bank reserves. The Fed bought $1.6 trillion of notes and bonds and paid for them by crediting banks with bank reserves; a portion of those reserves were eventually exchanged for currency, which has increased by about $300 billion; about $100 billion of those reserves were used by banks to back up increased deposits; and the rest of the reserves found their way back to the banks, who were content to just hold on to them in the form of "excess reserves." Banks were risk-averse too, after all, and reserves were a safe asset that paid at least some interest.

Most M2 growth went to deposits. The chart above shows the different components of the M2 measure of money, with the largest by far being savings deposits. It is not a coincidence that savings deposits account for virtually all of the increase in M2 since the Lehman Bros. collapse. Savings deposits have increased by about $2.5 trillion over the past four years, with $1.5 trillion of that increase going towards satisfying the public's hugely increased demand for money. In short, all of the extra "money" that the Fed created in the form of bank reserves ended up in the banking system. It never made it into the economy.

Money growth has not been excessive by past standards. As the chart above shows, M2 in the past four years has grown only marginally faster than it has on average over the past 17 years. Accelerations and decelerations in M2 growth happen all the time, and the last two—driven by increased money demand—don't appear unusual at all. When inflation was rising in the 1970s, M2 growth was averaging close to 10% per year. M2 growth over the past four years has been an annualized 6.4%, and that is just not enough to fuel a significant rise in inflation.

Benign inflation confirms this. Both the headline and the core version of the Personal Consumption Deflator are within the Fed's target of 1-2%. Although inflation has been unusually volatile in the past decade or so, on average it has not been problematic. This strongly suggests that the Fed's efforts to expand the money supply have been matched by the market's increased demand for money. If the Fed had not launched Quantitative Easing, we would probably have seen deflation by now.

However, inflation expectations are rising. The above chart shows the forward-looking inflation expectations that are embedded in the pricing of TIPS and Treasuries. Inflation expectations have been rising in recent months, but they are still only moderately elevated compared to historical experience. I think this reflects emerging fears on the part of the bond market that the Fed is likely to make an inflation mistake in the future, and that is a very legitimate concern.

The dollar is extremely weak. The above chart shows the value of the dollar against large baskets of other currencies, adjusted for differences in the inflation rate between the U.S. and those other countries. It is arguably the best measure of the dollar's value vis a vis other currencies. That the dollar is very close to its all-time low suggests that the currency market also is feeling uneasy about the Fed's stewardship of the dollar. At the very least it suggests a serious lack of confidence in the future of the U.S. economy. The Fed may have done an excellent job accommodating the world's demand for safe-haven dollars to date, but in the process they may have undermined the world's confidence in the value of the dollar going forward.

Gold and commodities are very strong. Gold and commodity prices have risen significantly in the past 10 years, beginning with the Fed's initial efforts to ease in response to weak recovery that followed the 2001 recession. This is basically the flip side of the dollar's general weakness following its peak in 2002. The world's demand for dollars has been eclipsed by an increased demand for physical assets, which in turn is symptomatic of the beginnings of a rotation out of financial assets that could fuel future inflation. Recall that the sharp rise in inflation in the late 1970s followed a sharp rise in gold and commodity prices in the first half of the 1970s. Gold, which is up strongly relative to every currency, is sending a strong signal that the world is concerned that inflation is going to rise.

Inflation has not risen yet, but that is mainly due to the fact that the demand for dollars has been very strong, and that increased demand has been driven by fears, uncertainty, doubt, and a general lack of confidence in fiat currencies. If confidence in the future increases, the demand for dollars is likely to decline. Will the Fed be able to reverse its quantitative easing and/or increase the interest rate paid on reserves in a timely fashion, enough so as to prevent an excess of dollars—and a significant rise in inflation—from occurring? That is the biggest question lurking beneath the surface today. If the demand for M2 should decline, there is the potential for a $1.5 trillion—or more—excess of dollars to develop. Looked at another way, there is $1.5 trillion sitting in bank savings deposits that could be spent, and banks' excess reserves could be used to make new loans and expand the money supply almost without limit. If the world just attempted to reduce its holdings of savings, $1.5 trillion could find its way into higher prices for goods and services, and that could fuel some significant inflation, and perhaps some additional growth, in the years to come.

In short, it's understandable that markets are reluctant to believe that things will continue to improve.

Next installment: fiscal policy


Jim said...

What I would be worried about the M2 GDP ratio chart is if the M2 numerator remains static and GDP falls. I think the chart portends hard times coming.

Unknown said...

Great post, loved the data. I was thrilled to finally see someone explain why deflation may be a problem. I have a few questions though. When you say:

"The Fed has not "printed money" in massive quantities as so many have been led to believe."

I understand they haven't printed money, YET. It's currently just numbers on a computer, until the banks start loaning in masses. This flood of new money could be highly inflationary, couldn't it? These "excess reservese" that they're creating out of thin air will eventually become money someday, 10 times the amount too with required reserves at 10%. So, down the road these created excess reserves will become required reserves, however, the over 9 times becoming new loans. Correct? And with all those new loans out there, how would it not drive up asset prices?

Public Library said...
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Public Library said...

Another way to look at it is the Fed has to pitch a perfect game when it decided to intervene in the markets. Ultimately, the Fed will need to pitch another perfect game to unwind.

Regardless of ones belief in intervening, the longer this goes on the less likely the Fed will pull it off and the bigger the potential error.

Sam: deflation is not a problem. Deflation is the flipside of inflation. Inflation is money printing. A decrease in prices = a benefit to society. However, the Fed is not in it for the beneift of society, they are in it for the banks.

Gloeschi said...

Poor Scott, I hope the audience at didn't laugh him out of the room.

According to Scott, the Fed "merely" supplied an "asset" in high demand.

First, the Fed is purchasing assets, so it is retiring assets from the market.

Second, if demand for money was so high, how come the "money" created ends up in deposits yielding nothing? Makes no sense.

It is correct that the Fed (apart from traditional seigniorage) is not printing money. BUT it is in cahoots with the government, which spends money into existence by running huge deficits. Supporting the necessary issuance of huge amounts of additional debt while suppressing the price on debt (interest rates) at the same time means the Fed is guilty of complicity in money printing, big time.

Anonymous said...

Gloeschi, I think that the base money used by the banks to buy more Treasuries to fund the deficit turns the base money into money when the federal government spends it. Then the money gets deposited into bank saving accounts of those who are beneficiaries (like the landlord of a social security recipient) who want to have cash in the bank. Likewise, an individual selling their Treasury bonds because they fear the price will go down in the future deposit the proceeds of the sale into their savings account because they like cash in the bank. Then the money is in a liquidity trap. At least this is what I got out of this post, among other things. The reason I am not replacing my car is that I like cash in the bank enough to drive around in an older car. I like money in the bank. It will take a lot of inflation to get me to buy products. I can be persuaded to buy real estate more easily, but it will take me believing that prices will increase in the future before I give up my precious cash in the bank. Absent inflation, cash in the bank is security. The stock market isn't a sure thing in the long run just yet so cash is king in the minds of many.

In the absence of QE, running federal deficits is not increasing the money supply as the money is borrowed and out of someone's bank account. To the degree that QE base money purchased auctions that investors didn't fully buy, then yes, the deficit spending is from "printed money". I think. I have been reading this blog for a while so I am catching on.

If required reserves went up $100 billion, isn't that lending of $1 trillion? Or is it just that these required reserves is from increased deposits from the increase in M2? In which case I guess the $100 billion it is just an allocation of excess reserves to required reserves. I guess the answer is in how much new lending there is since Lehman Bros. Consumer and business debt.

Benjamin Cole said...

Very thoughtful and insightful presentations.

I do think the world has changed in the last 40 years and the great inflation of the 1970s. Inflation may be dead for a long, long time, ala Japan.

Some say the Fed should stop paying interest on reserves, called IOR. I think this is right, they should stop.

Gold is worth what upper middle class and above Indians and Chinese say it is worth. No longer a USA inflation signal.

Copper is selling for less today than the start of 2008, and oil is down from the 2008 peak price as well. Commodities, unlike equities, more quickly correct speculative excesses. People start using less.

A good question on oil is not Peak Oil, but have we seen Peak Prices or Peak Demand?

At $100 a barrel, there is not a field in the world not worth developing, yet demand stagnates. Natural gas is subbed in.

As with 1979, we make been seeing a long-term peak price in 2008, as in for 20 years.

All in all, the Fed has been timid, peek-a-boo, hide-and-seek, untransparent, unaccountable and weak.

The Fed should have targeted robust growth in nominal GDP starting in 2008.