Unconventional Monetary Policy
The 2008 financial crisis reached one of its darkest moments in September of that year. In the space of two months, the U.S. financial sector experienced events that to many would have seemed impossible a few months earlier: Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) had been put into conservatorship and received a $200 billion cash injection from the U.S. Treasury, American International Group Inc. (NYSE:AIG) had to be bailed out with $85 billion, Lehman Brothers filed for bankruptcy, and a $700 billion bailout plan was signed into law in early October to arrest the panic surrounding the soundness of the financial system. These two months of turmoil ended with the Federal Reserve (Fed) cutting its key interest rate to 1% on October 29th.
In November of that year, the Fed introduced the first in a series of unconventional monetary policy programs, commonly referred to as Quantitative Easing (QE), through which it was able to purchase assets with newly created money.
By December 2012, the Fed had implemented a total of three QE programs with varying sizes, as well as Operation Twist - the purchase of securities in the 6 to 30-year sector and the simultaneous sale of an equal amount of securities with maturities of 3 years or less.
|Version||Date Introduced||Total Size ($ billions)|
|QE 1||Nov 2008||1,350|
|QE 2||Nov 2010||600|
|Operation Twist||Sep 2011||667|
|QE 3||Sep 2012||Unlimited|
As the table above shows, the Fed's final program (QE3) had the unique characteristic of being unlimited in size. Initially envisioned to purchase $40 billion of securities a month, in December 2012 the pace of monthly purchases was increased to $85 billion.
The cumulative result of these policies has been an engorged Fed balance sheet - one that has grown from $869 billion in August 2007 to well over $4 trillion as of June 2014. This can be seen graphically in the Federal Reserve's recent balance sheet trends website by adjusting the dates to the desired range as per the picture below.
What Has Been the Impact on Inflation?
Based on the evidence shown by the Consumer Price Index, the answer to this question would be: there hasn't been any. But why has this been the case?
Our understanding of money is a funny thing. Just through observation we can easily discern that even thought most of us never stop to think why, we intrinsically accept money as a medium of exchange and as a store of value. This holds true as long as we perceive that money is issued responsibly and that it is accounted for. If these conditions do not exist, we become suspicious of our money and try to exchange it for something else that we believe holds value. This is a simple way of thinking about monetary inflation.
Milton Friedman, who was in fact the first economist to quip that price deflation can be fought by "dropping money out of a helicopter" (Optimum Quantity of Money. Aldine Publishing Co. 1969. p.4.) is well known for arguing that "inflation is always and everywhere a monetary phenomenon" (Inflation: Causes and Consequences. Friedman, Milton. New York: Asia Publishing House.)
This Friedman axiom, as well as the historical record, goes some way to explain this innate human deduction that financing a budget deficit by printing money results in rampant inflation.
Given that QE is a policy through which money is issued to purchase assets (a large percentage of which are government issued), shouldn't we expect inflation to be out of control? Even the Fed has gone some way to link QE with an increase in inflation. In a 2012 publication titled Quantitative Easing: Lessons We've Learned, the St. Louis' Fed stated that the FOMC chose to pursue unconventional monetary policy as it was "concerned that deflationary expectations and sharp contractions in credit would stifle [the] recovery…" (NB. emphasis added.)
In a September 2013 article in TIME magazine, Christopher Matthews lists the concern that QE will eventually lead to inflation as one of the three myths surrounding the policy. Even Austrian economists, great critics of the Fed's policies as being inflationary, have tried to explain why QE isn't causing inflation.
Perhaps one of the most balanced explanations as to the lack of an effect on inflation by the QE programs comes from Professor Martin Feldstein. In an article dated June 28, 2013 and titled Why is U.S. Inflation So Low?, Feldstein argues that the reason that inflation has remained subdued in the U.S. is because of the lack of increase in the stock of money. He explains that as the Fed began to pay interest on excess reserves in 2008, this encouraged the banks to leave their excess cash safely at the Fed rather than to risk it by lending it out to businesses and households - something that would have resulted in an expansion of the money stock.
As he concludes, Feldstein points out that an eventual growth of spending by businesses and households, on the back of an increase demand for loans, could become the source of unwanted inflation.
Big Increases In Minimum Wage - What Will The Impact Be?
The debate around raising the minimum wage gathered momentum once more in early 2013 with President Obama making a push for an increase in the federal minimum wage to $9.00. By December, and after retail-worker strikes that swept the nation, it was being reported that 13 states would increase their minimum wage rates on January 1st, and that more states were expected to increase their rates later in the year.
February 2014 saw the minimum wage of federal contractors increased to $10.10 (39.3% increase). Most recently, Massachusetts signed into law a measure that will raise the state's minimum wage to $11 per hour. This is the highest of any state and represents an increase of almost 52% over the federal requirement of $7.25.
By simple deduction it is easy to argue that an increase in minimum wage will encourage consumption as low-wage workers will have more money to spend. This should results on an expansion of GDP.
However, predicting the impact of an increase in the minimum wage is a more complex exercise. The Congressional Budget Office (CBO) published a study in February of this year in which they projected the possible impact of increasing the minimum wage under two scenarios. In the first scenario, the wage is increased to $9.00 and left there in the subsequent years. In the second scenario, the wage is increased to $10.10 and adjusted annually for inflation.
Among its findings, the CBO expects in both scenarios a small decrease in employment - a bigger drop will take place in the scenario with the larger wage increase. Interestingly, the CBO also projects an increase in earnings for workers who are slightly above the new minimum wage. It also expects that higher-wage workers will find increased demand and earnings associated with their roles. This is to be driven by a greater than before demand for goods and services concomitant with the minimum wage increase.
Data from the OECD (below) shows how, since at least the year 2000, the minimum wage in the U.S. has been consistently between 31% and 39% of the median wages of full-time workers.
An increase to $9.00 will make this ratio 47.2%; an increase to $10.10 would make the ratio 52.9%. The OECD's historical evidence suggests that the ratio will tend back towards the 31% to 39% range. For this to happen, median wages would have to increase - something that concurs with the projections coming from the CBO.
Will Inflation Finally Take Off?
As we have seen, the policies the Federal Reserve implemented since 2008 have drastically expanded their balance sheet without a commensurate effect on inflation. Martin Feldstein argues that the reason for this is the lack of growth in the money stock. He explains that this has to do with the interest the Fed has been paying banks on their excess reserves, as this has kept them from lending to businesses and households. Feldstein has identified an increase in business and household spending as a potential source of unwanted inflation.
We have to consider the risk that an increase in business and household spending could be sparked by the changes in minimum wage that have already taken place and those that are to come in the near future.
As we have seen, the CBO projects an increase in the demand for goods and services following a move higher in minimum wage. They also expect this pick up in demand to drive up the pay of higher-wage workers.
Will this be the spark that ignites the increase in business and household spending Prof. Feldstein has identified as a potential source of unwanted inflation? Only time will tell.
Therefore, it is only prudent for investors to appreciate that the risks to higher inflation are increasing significantly. We are all well advised to keep a close eye on the developments around minimum wage increases and their impact on changes to inflation expectations.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.