The US Federal Reserve, the European Central Bank, Bank of England, and Bank of Japan all have struck the same liberally stimulative policy stance: zero short-term interest rates, combined with massive balance sheet expansion. Yet no major country sees any signs of inflation. With the words of economist Milton Friedman in mind - that "inflation is always and everywhere a monetary phenomenon" - we examine why four years of highly accommodative monetary policy have failed, so far, to generate any inflationary pressure in the US.
Our conclusion is that now is the time to worry about inflation pressures re-emerging, even if the current data is benign. The reasons why inflation was subdued in the aftermath of the financial crisis are now fading away, and 2014 and 2015 are likely to see a return of inflation pressure. Our earlier work on the Era of Dissonance puts our research into perspective and highlights why this report represents a major shift in our views going forward on inflation. Our post-crisis research focused on the dislocations to the economy caused by the nature of a financial recession with an emphasis on deleveraging and reduced risk-taking. Notably, we have remained aloof from the analytical camp that has worried about the Federal Reserve's accommodation policies leading to inflation pressures, and we have written extensively about why the second and later rounds of quantitative easing have not been particularly effective in raising the US economic growth rate.
We have focused more on trying to identify the triggers and timing associated with when the deleveraging and reduced risk-taking process would come to an end, and that led us to our perspectives for continuing improvement in the unemployment rate back in December 2011 and our favorable take on housing back in March 2012. Our views of declining unemployment rates and a rebound in housing were confirmed in 2012, and as we start to put our Era of Dissonance themes in the rearview mirror, we have come to the conclusion that now is the time to start worrying about future inflation and the most likely scenario (75% probability) is that core inflation will exceed 2% in 2014, and 3% in 2015.
A. Irving Fisher's equation of exchange: MV=Py
As it was for Friedman, our starting point is the Fisher equation of exchange, according to which every good or service included in annual nominal GDP (price (P) times real output (Y)) signifies a monetary transaction. Since the stock of money can be used multiple times in a year, the volume of monetary transactions must also equal to the product of the money stock (M) and the velocity of money (V). Within this framework, several generations of monetary economists have built various theories of inflation upon a foundation of now-standard assumptions. First, the government (usually the central bank) controls the growth of a specifically defined measure of domestic money supply.
Second, the velocity of money either holds constant or follows a predictable long-term trend. Third, while business cycles may cause it to vary in the short run, real GDP also follows a stable growth trend over the long run. These critical assumptions - that the velocity of money and real GDP are either constant or trending predictably, and that government controls the growth of the money supply - lead directly to the conclusion that inflation is determined by monetary policy over the long-term.
The caveat "over the long term" reminds us to heed another Friedman maxim, namely that the response of the economy (Py) to monetary policy actions is characterized by "long and variable lags." How long are these lags? What determines how they vary through time? Given an institutionally consistent and empirically measurable definition of money, does velocity actually hold constant or trend predictably?
The velocity of money depends in no small part on how one defines money. The narrower definition of money, known as M1, encompasses only currency and checking deposits. Most economists prefer to track a broader definition of the money supply, known as M2, which includes everything in M1 as well as various interest-bearing savings and time deposits. M1 velocity in the US trended steadily upward in the post-WWII period until banking deregulation initiatives threw it a curve ball in the early 1980s with the introduction of interest-bearing checking accounts, among other reforms. M1 velocity started growing again in the early 1990s with the information and Internet age, greater credit card usage, and faster payments processing. M1 velocity peaked with the US sub-prime mortgage debacle and subsequent global financial crisis in 2007-2008, and then collapsed. M2 Velocity was relatively stable until the 1990s.
Since M2 includes interest-bearing savings and time deposits, its velocity was not much affected by the various banking reforms of the 1980s. As with M1 velocity, M2 velocity also rose in the 1990s with the information age, before crashing with the recent financial crisis. The relative stability of the velocity of M2 from the 1950s to 1990 explains its favored role with economists. Unfortunately, the (lagged) statistical relationship between M2 and future inflation fell apart in the 1980s. By the late 1980s, the Federal Reserve was no longer paying even lip service to money supply targets, but was focused primarily on the role of short-term interest rates for the conduct of monetary policy.
B. Velocity and the Case for Inflation Pressures
The recent massive expansion of the balance sheet of the Federal Reserve has heightened the importance of understanding the possible future paths of inflation, and this has put a spotlight back on the velocity of money. It is important to appreciate that with economic theory, the devil is typically in the assumptions. If the assumptions are not robust, the theory will not provide useful predictions or policy guidance. In the case of monetary theories of inflation, the challenges lie in understanding the observed shifts in the velocity of money, changes in the relationship of bank reserves to the money supply process, and the role of the global economy in influencing domestic inflation.
Our analysis of these challenges provides us with a short list of five potential reasons why recent, massively accommodative monetary policy has not, at least yet, produced a build-up of inflation pressures in the US. Our basic conclusion is that though inflation pressures have been delayed, they have not necessarily been denied. Some more time may still elapse before inflation pressures emerge in the reported data. But emerge they will, and our estimates are that inflation pressures may arrive much sooner than the benign current environment might lead one to suspect.
1. Deleveraging associated with financial recessions lowers velocity
Financial recessions are different from more traditional business cycle recessions in that economies go through significant deleveraging by consumers and corporations in the aftermath of the financial shock. During the period of deleveraging, accommodative monetary policy, either in the form of zero short-term rates or asset purchases appears to work mostly to prevent the financial shock and resultant deleveraging from spiraling into a depression. Inflationary pressures are not created because the consumers and corporations have temporarily become interest rate insensitive. That is, during the deleveraging process both consumers and corporations are attempting to reduce their liabilities and to better align their spending, including interest expense, with their new, more realistic, and lower income expectations. Short-term interest rates can go to zero and long-term rates can be pushed down by central bank asset purchases. Yet while deleveraging is their focus, neither consumers nor corporations are going to spend or invest more. And importantly, they are not going to borrow more. This means that even though various measures of the money supply may be growing, the deleveraging activities of consumers and corporations are reflected in a sharp drop in the velocity of money.
By our analysis, US corporations made swift adjustments to the 2008 financial crisis, with most companies completing their deleveraging by end-2010. On the back of cost cutting, including employee layoffs, corporations rebuilt their profitability. They also allowed their cash holdings to rise to very high levels in the years following the crisis as both a prudent cushion against future crises as well as a recognition that the future was too uncertain to move into a robust investment and expansion cycle. US Consumers appear to have completed most of their deleveraging phase by late 2011. Mortgage debt seems more manageable, home foreclosures have slowed, and credit card debt is now rising again.
If we are correct in our analysis of the deleveraging impact on the velocity money, then it follows that the years from 2009 through 2011, when we roughly date the end of the deleveraging process in the US, would have to be added to the traditional long and variable lags in monetary policy. Put another way, due to the post-crisis deleveraging impact, the clock on the link from expansionary monetary policy to inflation pressure did not even start ticking until the end of 2011.
2. Money supply process disrupted by tighter bank regulation
A financial crisis often begets new legislation, and in the US this time around we have the Dodd-Frank Act. Years after its enactment, not all the rules for the financial system have even been put in place by the designated regulatory authorities. What is clear, though, is that banks are now holding more capital and capital of higher quality may be required down the road. The transition of the US banking system to tighter credit standards, improved risk management, higher quality capital, and higher capital ratios all have worked together to change the money supply process and make more uncertain the link between the expansion of the Federal Reserve's balance sheet and the creation of money, regardless of how defined. That is, the assumption embedded in older monetary models of inflation that the Federal Reserve controls the money supply is neither robust nor useful for predicting inflation in the current environment. The Federal Reserve can control the monetary base, but economic agents ultimately determine how much money is created.
The asset purchases by the Federal Reserve as part of their quantitative easing programs have resulted in a $2 trillion expansion of reserves held by depositary institutions at the Federal Reserve. What is critical to note is that this expansion of total banking system reserves has gone almost completely into the category of excess reserves (i.e., Excess Reserves = Total Reserves minus Required Reserves). That is, the Federal Reserve essentially "printed" the money for its asset purchases by crediting the depository institution's account that sold (i.e., brokered) it the Treasury bonds or mortgage-backed securities, effectively creating federal funds. But the banking system did not use those newly created federal funds to expand loans, which is the normal assumption when incremental federal funds are created. So these new reserves remained as excess reserves and never migrated to the required reserve category. This means that for a given expansion of the monetary base (i.e., total bank reserves plus currency outstanding), the measured money supply does not expand at its old multiple - known as the money multiplier - because the traditional multiplier impact has been rendered almost non-existent in the post crisis period of tighter bank regulation (not to mention the previously discussed lack of demand from deleveraging consumers and corporations).
3. Everyone is doing it together - No FX feedback loop to accelerate the inflation cycle
Monetary economists often build their models assuming there is only one big country in the world. These closed economy models by assumption ignore the influence of exchange rate trends on the velocity of money. Our analysis of an integrated global economy suggests that the inflationary pressures from the current monetary accommodation from the US Federal Reserve may have been delayed considerably by the fact that all the major central banks are in the balance sheet expansion game together.
If only one central bank adopts a dramatically expansionary policy while others do not, there is typically a feedback loop to inflation created by currency weakness. This can work in the other direction, too, as it did for the US in the 1980s. In the 1970s, the US suffered both a depreciating currency and inflation rising to its peak of over 14% in March 1980. At the time, what surprised many market observers who built their views around closed economy macro-economic theory was just how fast the US inflation rate declined-to less than 3% during 1986. The considerable strength of the US dollar in the early 1980s had created a virtuous feedback loop, with a very strong dollar putting downward pressure on prices that accelerated dramatically the disinflation process, shortening the traditional long and variable lags embedded in monetary policy.
In essence, this time around, compared among each other, the US dollar, euro, British pound, and Japanese yen, are effectively all absolutely weak currencies. This means exchange rate markets are really deciding which currency is relatively weaker than the others, which is more difficult than when one currency has strong attributes and the other weak attributes. With no FX feedback loop to inflation as there was for the US in the 1970s and early 1980s, the time pattern of inflation pressures may have been delayed by years.
4. Japan's expansionary monetary policy may be modestly dis-inflationary for the US
Taking the FX feedback loop one step further, we now need to consider what is happening in Japan. Japan is the outlier now; as it is taking quantitative easing to a whole new level in its attempts to achieve a 2% inflation rate after two decades of mild deflation. If the Bank of Japan can create its own FX feedback loop, our analysis suggests it has a good chance of achieving its 2% inflation target after years of zero short-term rates failed to work.
So far, since the announcement and then the early implementation of the massive asset purchase programs from the Bank of Japan, the yen/dollar has depreciated from the 77-80 range of the summer of 2012 to just over 100 yen per dollar in early May 2013. If the asset purchases continue on the announced schedule, then the added supply of yen allows for one to develop scenarios for the yen/dollar to head for the 120-140 range. The effects of the Japanese yen depreciation on US (and world) inflation may be slightly dis-inflationary and work to further reduce the US velocity of money.
The impact on US inflation comes from the threat of competition from Japan and its depreciated yen that can affect sectors such as automobiles and technology. The fact that many Japanese goods are now assembled in the US, although they may benefit from cheaper parts from Japan, limits the direct impact of yen depreciation on US inflation. The depreciation of the yen, however, has done wonders for the Japanese stock market, suggesting investors expect wider profit margins if not more sales.
5. Fiscal austerity provides some short-term disinflationary pressure
The monetary nature of inflationary pressures is a long-run concept. If fiscal austerity is being applied in the short-run, the austerity and the related lower economic growth rates may delay the onset of inflationary pressures. The relationship of shifts in fiscal policy to the velocity of money, however, is a little more nuanced than the other factors we have discussed. If one starts with the assumption of constant velocity, then fiscal restraint that leads to less real economic growth in the short-run would lead to more inflation, since by assumption the MV side of the accounting identity has not changed and real GDP is lower, so prices should be rising. It just does not work that way in the short-run. A key indirect effect of fiscal austerity is to depress risk-taking activity and spending habits, putting downward pressure on the velocity of money. The downward pressure on velocity is the defining attribute which causes fiscal austerity to lead to both a drag on real economic growth and less inflation pressure at the same time.
More specifically, in the recent past, the US had severe cutbacks at the state, local and postal service level in 2009-2012, with over 800,000 jobs lost from these sources. This number of jobs lost is key to appreciating the dis-inflationary impact of sustained state and local government cutbacks. On the federal level, austerity only started in 2013, with small tax increases and the modest spending cutbacks included in the sequestration process. Even though it appears state and local governments have largely achieved a balance between their revenues and expenses such that further job cuts are not necessary from that source, we foresee a sustained period of gradual austerity at the federal level serving as a small drag on the growth potential of the economy. Or, in terms of monetary economics, the drag from fiscal austerity will keep some continued downward pressure on the velocity of money in 2013, as it prevents the US economy from accelerating its real GDP growth rate out of the 2% zone and toward 3%.
C. Debate in the markets: Inflation denied or just delayed?
The critical question for inflation projections in the US is whether the velocity of money, regardless of how defined, is in terminal decline. If so, there may never be any inflation pressure from all the massive monetary accommodation. As we work though the various causes of the decline in the velocity of money, our conclusion is that the inflation pressures have not been denied, only delayed. The deleveraging process for consumers and corporations is largely complete by our analysis. We think this source of downward pressure on the velocity of money was the powerful cause of the drop in 2009-2011, but we believe it is no longer active. Based only this factor, though, we would start the clock for Professor Friedman's long and variable lags at the end of 2011, not when zero rates and quantitative easing first were commenced in late 2008.
The US banking system has moved impressively to improve its capital ratios since the financial crisis, and it is far ahead of certain other banking systems, such as those in Europe, for example. Despite the slow introduction of many Dodd-Frank rules, we see this source of disruption for the money supply process slowly fading away as a factor. We already are seeing signs of a return to more normal banking system rules of thumb, where the expansion of the economy, as evidenced by consumer and corporate activity, will determine the pace of new lending.
From the FX sector, we argue that the lack of a feedback loop to inflation and inflation expectations may have added as much as a year or so in terms of lengthening the long and variable lags in monetary policy. This judgment is of a qualitative nature, as we are in uncharted territory with simultaneous quantitative easing and zero rates from all the major central banks. And while we want to note the disinflation aspect of Japan's weaker exchange rate, we do not want to overstate the case. Japan is the third largest economy in the world, but its companies have factories in the US and over the world, not simply in Japan. Japan's policy of massive monetary accommodation and allowing its currency to depreciate will only slow US inflation a tiny bit in 2013, not stop the long-term pressures from the Federal Reserve's monetary accommodation from eventually emerging.
Finally, there remains some short-term downward influence on the velocity of money due to mild fiscal austerity. Our take, however, is that since the fiscal austerity is only a small drag on economic growth and not enough to cause a recession, this factor is ebbing away in terms of its influence. When we put this together, all of the five factors causing the velocity of money to crash in the post-recession period have either run their course or will do so very soon. Thus, the sweet spot for identifying emerging signs of inflation pressure may be late 2013 or early 2014. For the US core inflation rate, excluding food and energy, to rise toward 2% and then through that level may require two more years without the feedback loop from the currency markets.
From a policy perspective, the Federal Reserve has signaled that it would like to see both unemployment below the 6.5% rate and core inflation moving past its 2% target and above 2.5% before it commences raising the federal funds rate. By our projections, of these two criteria, the inflation criterion is the controlling factor, since we expect the unemployment rate to arrive in the 6% territory during 2014. This means by our analysis, we may be waiting until 2015 for Federal Reserve action to commence raising its federal funds rate target. Most FOMC members think it will take longer - 2016 or beyond.
The markets' interpretation of when future inflation pressures will arrive and prompt Federal Reserve action are probably more similar to the consensus expectations of the FOMC members than our own most-favored scenario of a more rapid emergence inflation pressures now that the downward influences on the velocity of money are fading away. For example, the recent downward pressure in gold prices suggests that participants in that market are no longer afraid of a return of inflation.
Also, we observe that activity in the US LIBOR futures markets also appears to agree with the longer-dated expectations, as trading volumes in the shorter-dated maturities remain depressed. This sets up the possibility that even a whiff of inflation pressure could destabilize US interest rate markets, since any sign of inflation pressure would be considered a "surprise" according to the consensus.
Another interesting observation is that options trading activity in the rates sector has been gaining considerable traction. Options can be an attractive addition to futures in the risk management arsenal, given the complexity of the uncertainties around the future path of inflation and the timing of potential Federal Reserve action. Market participants appear to be increasingly embracing this valuable risk management tool.
In closing, we return to our most-likely scenario that the current benign state of inflation may be a false signal concerning the speed with which future inflation could approach. Our interpretation of the sharp declines in the velocity of money since the onset of the financial crisis suggests that all five of the critical factors causing that drop in velocity have either worked their way through the system or soon will. This leads us to the scenario in which the velocity of money will soon turn upwards and bring with it inflationary pressures fueled by the lagged effects of the massive monetary accommodation provided by the Federal Reserve.
Only time will tell, but we caution against forecasting future inflation based primarily on the recent past, since the recent past contains some very special circumstances for which we think we have a reasonable interpretation. And, as we noted in the beginning of this analysis, we are not in the camp of having to explain why previously aggressive inflation projections did not happen. Our earlier post-crisis research focused on the dislocations of the Era of Dissonance and why the second and later rounds of quantitative easing by the Federal Reserve did not work as well as anticipated. With these dislocating factors fading into the background, we are now prepared to commence worrying about future inflation pressures and the difficulties and challenges the Federal Reserve will face in the "exit phase" of its experiments with massive balance sheet expansion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.