We Can't Rely on the Fed to Prevent Inflation

With the Federal Reserve Open Market Committee (FOMC) meeting this week, we are all reminded of what occurred the last time it convened. Traditionally, the FOMC meets to set interest rates. Having already reduced interest rates to near zero, the last meeting left little to be done on that front. However, the committee did not refuse to act. Instead, with a few strokes of the computer, the FOMC magically created over $1 trillion of new money to be pushed into the economy.

Recalling my college years, we were all taught that excess money floating through the economy leads to inflation. With precisely this goal in mind, the Federal Reserve (Fed) has increased their balance sheet from $866 billion a year ago to over $2 trillion. Despite such an increase, the inflation rate has not grown and more people remain worried about deflation than inflation. How can this be?

The answer lies with the money multiplier. Returning to the lessons of my economics classes of yesteryear, each dollar I spend has a multiplying effect on the economy. If I go to a restaurant for dinner and leave a $20 tip for the waitress, she then spends that money on her dry cleaning. The dry cleaner spends some of it to pay his employees, who then spend their share on groceries. Supermarket workers receive wages from the proceeds, go out to dinner, and start the process again. My initial $20 outlay has a multiplying effect that contributes to economic growth.

Using this process, we can estimate economic activity as the money supply multiplied by the velocity of money (the multiplier). Currently, the multiplier has collapsed as consumers have curtailed their spending. For that reason, the massive increase in money supply helps offset the economic collapse without igniting inflation.

That may explain our current state, but we all hope it is temporary. Eventually, the economy will resume growth and the multiplier will increase. At that time, the economy will respond to the Fed's injection of money and inflation will reappear. In theory, the Fed will interpret that event as a reason to reduce the money supply. If the Fed does this correctly, growth will be reasonable and inflation contained. Unfortunately, though, I have little faith in the Fed acting correctly.

Considering this is the same group that could not foresee any of the recent asset bubbles and has always had uncoordinated ad-hoc approaches to stemming crises, those who believe it will magically spot the turn in the economy and reduce monetary stimulus are naïve. Further, even if the Fed possessed such forecasting skills, which it does not, the political pressure surrounding monetary tightening would be immense. As we have all lived through a horrible recession, any attempt to moderate growth will be widely scorned. The Fed will opt to keep the monetary spigot open while reminding us that Japan prematurely tightened monetary policy and quelled its own economic recovery.

As investors our job is to analyze this injection of cash for what it is-a smoke screen. The Fed has aggressively expanded its powers during this credit crisis and will seek to forestall congressional oversight of its future actions. Peace with Congress will exist with the Fed keeping rates low and the money supply high. For a time, the Fed's targeted buying of assets will achieve these goals, but the markets will eventually win. At some point, the leash will break, inflation will skyrocket, and the next bubble will burst.

Comments

[mnecon:]

One flaw in the argument is that the money multiplier is regulated by the FOMC by regulating the reserve ratio(the money multiplier is simply the inverse of the reserve ratio).

Apr 28 10:45 AM

[kelm:]

Even if we believe the Fed is hypersensitive to the start of inflation and correctly identifies it their ability to act without damaging the economy is contingent on unemployment, credit spreads, and economic growth being back on track. It seems unlikely that we will be so fortunate that the onset of inflation coincides perfectly with a revived economy and employment. We can expect inflation to return.

Apr 28 10:55 AM

[Leftfield:]

I believe the banking system has far more to do with the money multiplier than the consumer. Their leverage is far greater, especially ex-Glass Steagall. Their curtailed lending needs to be mentioned.

The corruption of standards as well as of people is rampant. We are still looking for the next quick fix to tide us over while we hope for a miracle as we continue to decline. This is like Detroit. Inevitable less borrowing and spending by consumers will take down more houses of cards in our grossly misalocated economy. The tax take will be far lower and many government spending programs and many businesses will fold.

Government should not attempt to continue bubbles while adding more deadweight like carbon caps. They can only hope realistically to cushion the blows. They are blowing their (our) wad to help bankers. The path they are taking us on will almost certainly fail and leave us holding the empty bag for our leaders and as pauperized wards of the state.

Apr 28 11:12 AM

[FDNY RET:]

Your injecting philosophy into kindergarten math: It's simple!.
There is a finite amount of Commodities on this earth and the goods which can be produced/consumed from them.
You have only to divide the above into the dollars available to pay for them to get the prices--more dollars=higher numbers=inflation.

The only people who don't understand this first lesson of economics are some Ubangi Savages in Zimbabwe, who thought if they threw out the British and seized their farms they'd be better off.

They couldn't do the division above and subsequently learned they can't farm either, so Now-they go to the river and pan gold to buy a loaf of bread. Hopefully we know better- you can't live large by Turbo-charging a printing press.-----BUT--->

If we don't wise up it'll be ---"Now we gather at the river"
Better to put the gold back under the buck!!

Apr 28 11:20 AM

[Vox Rationalis:]

"Currently, the multiplier has collapsed as consumers have curtailed their spending..."

The multiplier has not collapsed. Consider that the savings rate has increased from perhaps zero to 5%; consumption has declined then by only 5%. Certainly, in a geometric progression a 5% decline is significant, but it is not a collapse. Velocity is nominal GDP divided by the money supply; most of its decline is explained by a decrease in GDP and an increase in the money supply.

"For that reason, the massive increase in money supply..."

Since August, NO measure of the money supply has increased more than 13%.

"Unfortunately, though, I have little faith in the Fed acting correctly. Considering this is the same group that could not foresee any of the recent asset bubbles and has always had uncoordinated ad-hoc approaches to stemming crises, those who believe it will magically spot the turn in the economy and reduce monetary stimulus are naïve."

The Fed's actions since Lehman's collapse have been extraordinarily effective. The economic impacts of the credit crisis could have been much, much worse.

"Further, even if the Fed possessed such forecasting skills, which it does not..."

Currently, banks have more than $900 billion in reserves on deposit at the Fed, which were not there last year. As banks and the economy return to health, these reserves will be withdrawn and lent. What forecasting skill is required to see that these balances are declining?

"...the political pressure surrounding monetary tightening would be immense."

Do you think Bernanke hasn't been under political pressure this last year? Did you watch ANY of the Congressional hearings?

"The Fed has aggressively expanded its powers during this credit crisis and will seek to forestall congressional oversight of its future actions."

Oh, I see, it's a conspiracy. Well why didn't you just say so. Princeton economics professors are well known to be power-hungry.

Apr 28 11:23 AM

[Hot Richard:]

@ Vox: "The Fed's actions since Lehman's collapse have been extraordinarily effective."
No critic of the Fed's actions believes the final conclusion should be written at this time. I'm now going to "effectively" manage my personal finances by going $500K into debt, quitting my job, and surrounding myself with jet skis. It'll be "extraordinary" for a month!

@ the author: "The Fed has aggressively expanded its powers during this credit crisis..."

Never waste a good crisis! Every member of Congress gets this inked on them their first year. I guess the Fed learned, too. It's all about expansion, baby. At YOUR expense.

Any deflation is simply a matter of temp excess of supply as demand crashed. I might be wrong and am willing to take bets.

What's the definition of inflation again?

Apr 28 12:37 PM

[Permacritical:]

An important point to make under the velocity of money or the multiplier as the author states is that we can have an increased multiplier in the restaurant example but if all that money velocity gets blown on consumption then all we have is a worthless service, retail, and information economy. More than likely the consumption is based on buying things made in other countries, particularly when American companies' credibilty have taken a huge kick to the yarbles. Inflation is seen most acutely in the downsizing, outsourcing, and exporting of our jobs overseas. American make decent enough cars, but the main reason they lose is because their cost structure is so much higher than other companies and they are not open to changing that, even when faced with no job at all. This is amazingly arrogant and greedy, that sense of entitlement. Fine - you have no job now! How do you feel!?

Apr 28 01:57 PM

[Thomas J. G...:]

With the Federal gov't spending money in excess of tax take something has to give. Either Treasury engages in genuine borrowing, which I would argue would drive interest rates up, or they print money and monetize the national debt. My basic argument is that Federal deficit spending forces the Fed to print money. I think we didn't see any inflation up to 2008 because of the dollars status as the world reserve currency and large parts of the world were increasing their holdings of dollars. I've never been able to get anyone to explain to me how the Federal gov't can spend money in excess of tax take and the Fed not print money to cover it.

Apr 28 02:10 PM

[donzelion:]

If the money supply operated today the way that it did when the Fed was created, inflation/deflation models might make sense. However, risk - and risk trading/shifting - creates a whole new wrinkle in money supply analyses, something Keynes and Friedman never encountered or digested ("animal spirits" comes close, but the concepts are limited to "extraordinary circumstances" in Keynes' models).

Economists tend to avoid focusing upon aggregate effects of risk shifting ("externalities" and "transaction costs" muddle up beautiful models). After all, the tangible effects of risk shifting - war, pollution, endemic poverty, relentless corruption - these things are far closer to the "normal, real world" that history reveals than the last 100 years of industrial/post-indust... capitalism in the developed world.

Apr 28 02:56 PM

[MIKETRADER:]

I am buying ZBs & ZNs ahead of FOMC meeting.... I think the markets is testing and underestimating the will of the FED on its QE approach.... I also think there’s an implicit ceiling on 10yr and 30 ry rates at 3% and 4% respectively, this with the purpose to keep mortgage rates down....

I don’t think the markets realize that you cannot mess with the FED and PIMCO on what they want the market to be.....

Apr 28 03:18 PM

[levin70:]

Sean

Agree with your article

I would add that the "elegant" tools available to the FED to create money are unfortunately "lacking" when looking at the toolset to remove the previously created money. The options are (1) sell the assets purchased to drain liquidity (while theoretically possible, this solution may not be available in the timeframe needed [more than likely scenario imho]) (2) raise interest rates to incredibly high levels to destroy the demand for money just created (this is the "best" instrument, but its blunt and it reverse what was just accomplished or (3) the FED would issue its own bonds (of course this would require the FED to compete against the US Treasury for those scarce dollars, which would require an ever higher rate to attract those dollars [which leads back to #2 above])

Doesn't look good does it?

Apr 28 04:48 PM

[nobby73:]

I still think stagflation is the most likely outcome. Prices will rise, but sales will remain moribund. I'm concerned by money multiplier concept in this situation. The fact is, the whole economy, especially at the consumer level is over-leveraged and can't afford to take out any more debt. The Fed gives the money to the banks, the banks make some attempt to lend it out (and remember they are trying to fill in for the "shadow banking" collapse) but can't find the decent credits.

So, to use the waitress analogy, if you give her a $20 tip, the correct thing for her to do with it today is to reduce the debt on her credit card. If you give her another $20 tip tomorrow, again the best thing is to reduce the credit card debt. The thing is, she's got $10k balance on her card and has suddenly realised this is a big problem.

Someone said it was like trying to pull a brick out of the wall with a piece of elastic - the danger is when the brick finally comes loose, it is liable to hit us in the face.

Apr 28 05:14 PM

[conceptwizard:]

The Fed has to be careful by removing excess liquidity to prevent inflation, the central bank can cause the sudden collapse of speculative excess, and it can also hurt healthy recovery or growth by constricting the money supply. There is now a near-consensus among economists that lack of liquidity caused the Great Depression.

Apr 28 10:06 PM

[MBA "Stud"ent:]

We will get a double dose of inflation.

First we have the money creation the author mentions. This puts more dollars in the market which makes them less scarce. More dollars going for the same amount of goods.

Second the debt of the US is too high and our currency will be worth less compared to other countries. The rise of oil prices and commodity prices that happened in 2007 and early 2008 will return. This will cause a rise in prices for everything Americans buy. Our purchasing power compared to other countries is going to take a big hit.

Apr 28 11:54 PM

[Vuke:]

MBA Student gets an A+. More and more paper beginning to chase a now dwindling amount of things means only one thing: Inflation.

If the engine finally restarts the costs of fuel, copper, steel and food will require more paper to re-boot; i.e. inflation.

Look on the bright side. The Fed has managed to devalue the dollar by 96% since its inception so, what's another 2 or 3 percent? True, that's 50% to 75% of what's left of it, meaning $2,500 gold, $75 silver, $10 copper and $1M houses with the bonus of a debt now much easier to service.

Computing power costs will continue to decline so, with hedonistic adjustments the Fed will be able to stay within "guidelines". They have done just that through 96% of the journey so far.

Apr 29 02:17 AM

[storm999:]

Inflation will skyrocket -meaning what exactly 5%, 10% 20% and for how long? Personally, I think the fed will wait until inflation is around 4% and then they will tap on the brakes, anything less than 4% and they might push us back towards deflation, not because they are idiots but because it is damn hard to fine tune an economy. If I am right inflation will peak about 7-8% and the panic pundits will be talking about 15-20% "hyperinflation".

You are right that Greenspan was able to blow all kinds of asset bubbles but that was mainly because the most of the governors bought his free-market rhetoric. Since, even he has renounced his former ideas, I expect the board to be a little more proactive.

Apr 29 02:36 AM

[craigdude:]

so ----stagflation----- is rising prices and cost of goods but no -one buing? ok I understand now- and--- deflation ---is temporary oversupply of goods sold cheaply and which are not being purchased because of decreased spending because of job losses?- then deflation will have to give way due to the oversupply of goodsmanufactured when there was demand--- finally running out? And then the new supply of goods manufactured will take more dollars to purchase due to the dollars devaluation because of oversupply (massive printing)of currency? Thus the beginning of inflation? So this is why we don't have inflation yet- there are alot of goods in warehouses which were made at an earlier date? and soon inflation will set in? As I understand it- Gold will increase in price with inflation- I certainly hope so- and what to invest in after gold tops out again? Property will always have some value- but the property taxes have increased while rents have declined- making the prospect of being a landlord increasingly worrisome as a profitable way to earn any income. any help here?

Apr 29 08:10 AM

[ArtfulDodger:]

It's fun to read about the economic process. Thank you for the article, Sean Hannon.

I imagine, though, that the vast majority of the planet would tell us to get a life. Or, to get a job.

Good comments all around, too.

Apr 29 08:49 AM

[Thomas J. G...:]

ArtfulDodger - Economics, sport of the Gods.

Apr 29 12:24 PM

[MBA "Stud"ent:]

I think investing in foreign currencies is a good idea since our currency has to go down when world growth returns. I also like commodities for the same reason.


On Apr 29 08:10 AM craigdude wrote:

> so ----stagflation----- is rising prices and cost of goods but no
> -one buing? ok I understand now- and--- deflation ---is temporary
> oversupply of goods sold cheaply and which are not being purchased
> because of decreased spending because of job losses?- then deflation
> will have to give way due to the oversupply of goodsmanufactured
> when there was demand--- finally running out? And then the new supply
> of goods manufactured will take more dollars to purchase due to the
> dollars devaluation because of oversupply (massive printing)of currency?
> Thus the beginning of inflation? So this is why we don't have inflation
> yet- there are alot of goods in warehouses which were made at an
> earlier date? and soon inflation will set in? As I understand it-
> Gold will increase in price with inflation- I certainly hope so-
> and what to invest in after gold tops out again? Property will always
> have some value- but the property taxes have increased while rents
> have declined- making the prospect of being a landlord increasingly
> worrisome as a profitable way to earn any income. any help here?
>

Apr 29 04:29 PM