Thursday, July 30, 2009

Inflation? What Inflation?

I've spent the last couple days sitting in a seminar at INTAN on 1Malaysia. So far its been an interesting experience, with some good thoughtful speakers (as well as some not so good ones). There are some takeaways I'd like to talk about here, not so much on 1Malaysia but some of the nuggets that got bandied about, particularly on distributional issues. But this post will be tangential to that.

The seminar was supposed to be opened by the Chief Secretary to the Government yesterday, but due to a scheduling conflict, INTAN replaced the morning session with an impromptu 1hr talk by Lee Heng Guie, head of economic research at CIMB Investment.

No big surprises in his MY economic outlook - weak recovery in developed economies, and Malaysia should see positive growth in the second half of this year. He gave me some ideas that I'd like to follow up on statistically (US PMI as a leading indicator for MY exports for instance), but he repeated a stylized fact that is unfortunately all too common - quantitative easing (aka printing money) in the US will lead to higher inflation and a depreciating USD going forward. I'll buy (with reservations) the depreciating USD story, but inflation is by no means a given and its source will not be due to the Fed's liquidity injections or printing presses.

I'm seeing this high inflation story a lot in both the press and the blogosphere - this BusinessWeek article is one mild example of inflation hysteria (on a sidenote - Arthur Laffer is a prominent economist? Prominent maybe, but calling him an economist of any standing outside conservative circles had me choking).

You can get even more extreme drivel if you do a Google search for "libertarian gold nut" or Ross Perot. If I sound caustic on this subject, it's because I have little patience for a seriously outmoded form of monetary system that is so obviously economically unbeneficial (you can find my thoughts on gold here and here). Zimbabwe and the Weimar Republic frequently appear as models of comparison - as if the situations are at all comparable. The Fed is very far from triggering increased inflation, much less hyperinflation.

But what's wrong with the popular picture of QE driving inflation expectations? On the face of it, higher inflation is what we should expect: basic economic theory says that an expansion of the monetary base for a given level of output will necessarily turn up as an equivalent increase in the price level. As the saying goes, too much money chasing too few goods.

There's no doubt that the Fed, along with other major central banks have indeed conducted liquidity operations and QE on an unprecedented scale during the depths of the crisis. And under ordinary circumstances, this should indeed put upward pressure on the price level. The problem with this narrative is that it is essentially a static equilibrium analysis, which ignores two things:

1. The level of output has fallen below potential
2. The demand for money has increased

With slack in the economy, increases in the money supply will not cause inflation as both firms and workers lack pricing power. Firms can't increase prices without suffering loss in demand (and therefore profits), while workers can't demand higher wages in the presence of high unemployment. Also, under the present circumstances, firms and consumers prefer holding money rather than spending or investing it, which raises the amount of money supply that can be supported at a given level of output - again non-inflationary, as money velocity has fallen.

Most economists intuitively understand these factors, so much of the serious discussion is concentrated on what could happen after a recovery. If output closes on its long term potential and velocity rises back to its normal range in the next couple of years, won't the increase in the monetary base push inflation expectations along?

This is where the central banks' exit strategy becomes important. I've become far more sanguine on the ability of the Fed and ECB to unwind their balance sheet expansion than I was just a few months ago. There are a few reasons for my thoughts on this:

1. The monetary transmission mechanism is and will continue to be broken
The Fed's liquidity operations are not having an impact on the broader economy. The "massive" increase in the monetary base is not turning up as a corresponding increase in the broader money supply - the money multiplier has fallen. In fact M2 growth is hovering around its long term average of around 7% despite double-digit M1 growth (log annual changes; 1960-2009):

There are a few things going on here, of which the first is the increase in the demand for money I mentioned above. Secondly, banks are still recovering from the shellacking of the past year, and aren't that eager to lend especially as house prices are still trying to find a stable bottom and unemployment continues to increase. This situation is something that will in all probability take a few years to resolve, which gives time for the Fed to reverse its purchases of securities. Third is that the ongoing deleveraging of the shadow banking industry will continue to exert downward pressure on liquidity. And finally, the Fed (and a few other central banks) are using some unorthodox methods, which leads to my next point.

2. Paying interest on reserves
It used to be that banking reserves kept at the central bank attracted no income. This meant that banks would immediately utilise any excess over statutory reserve requirements, as reserves still had to be funded - reserve money was a dead loss. Now the Fed is paying overnight rates on all reserve funds, which means that banks should be indifferent to keeping their money in their reserve account or the money market. The importance of this is that the Fed can fine tune their control over the timing of shrinking their balance sheet. They don't need to mass dump securities on the market to mop up excess liquidity and potentially take a loss - they can raise the interest rate on reserve funds instead.

3. The Fed isn't actually printing money (at least, not so much you'd notice)
QE is such a bad couple of words that any hint of it has inflation hawks yelling blue murder. But how much monetization of government debt is the Fed actually doing? They have on their books just under US$700 billion, or something like RM2 trillion, worth of treasuries. On an absolute scale that sounds like a lot of money - it's rather larger than for example twice the entire M3 money supply of Malaysia. But scaled against the actual US national debt, it's somewhat less than massive at under 9% of estimated treasuries outstanding (held by the public) for 2009. If you include official holdings of treasuries, the ratio is even less. More importantly, the Fed is buying T-bills off the open market rather than at auction, so the effect on the monetary base is actually net zero and also has the impact of capping long term interest rates.

Based on these factors, I don't think monetary expansion will support a rise in inflationary expectations over the medium term - inflation is more likely to come about from elevated commodity prices. What I think will happen however is a general rise in interest rates, especially at longer tenures as the Fed only directly controls the 1 month rate.

I don't think the Fed has that much appetite for more QE than it absolutely has to - they're committed to another US$300 billion by September, but there's lukewarm support on the FOMC for continuing that program if I'm reading the signs right. And higher interest rates will also provide some notional support for the USD - which makes the USD collapse story less likely as well.

Technical Notes:
US money supply data from the Federal Reserve, estimates of US national debt from the Congressional Budget Office. The Fed's current holdings of treasuries is available here.


  1. The secular decline in the US$ is likely to come from a different issue: the record rise in US gov debt/GDP means that a surge in treasury issuance to fund the deficit or taxes will have to be raise to 60% and above in the next few years. Either way, foreign investors in US assets will demand higher yields or lower prices before coming back to own US assets.

    So once the US$ declines, the cost push inflation scenario arises in conjunction with higher commodity prices. Are there any caveats to this scenario?

  2. Salam saudara,

    Diminta agar saudara dapat memanjatkan artikel-artikel di bawah kepada top management PNB. Terima kasih:




    Cubaan untuk mengatur pertemuan dengan CEO PNB dengan penulis blog tersebut sering tidak kesampaian. Terima kasih.

  3. Nehemiah,

    Your thoughts mirror mine - inflation if it does come into the picture will come through other sources, and not from monetary expansion which was the point of my post.

    But even then I'm not totally convinced that there will be higher US inflation, or a significant depreciation of the USD going forward.

    The CBO's baseline scenario has the US debt to GDP ratio rising from 56% in 2009 to 70% by 2012, and 82% by 2019. That sounds high...until you start comparing it against other OECD countries. The US debt ratio is starting off from a fairly low base, and fiscal expansion is happening in all major economies, if not quite on the same scale.

    Hence my thinking is that the impact on USD bilateral rates against major currencies of fiscal deficits will actually be fairly minor. But the upshot of this will be higher long term interest rates across the board.

    On the commodity front, my feeling is that consumers and businesses started adjusting to higher prices since 2007, and with continued slack in Western economies the impact of higher prices won't have second-order effects. US output for instance won't get back to potential until the 2011-2012 timeframe.

    Just as important, I think commodity markets are too optimistic on the prospects of recovery. China's massive stimulus is driving commodity demand right now, but it doesn't look sustainable - there's a lot of leakage into "unproductive" activites.

    But all this underscores that a weak recovery, high interest rate scenario is the most likely outcome.

    The real Joker in the pack in my view is an appreciation of the Renminbi. China's taking over the role of global manufacturing base has exerted deflationary pressure on global prices of manufactures. That's going to reverse over the long term as China's economy matures.

  4. Anon,

    Am I outed already?!

    YB, PNB management is aware of those articles. More than that I'm afraid I can't comment.