Handle With Care: Inflation, Monetary Policy, And A Fragile System Ready To Crack

by: Colin Lokey

Jeffrey Lacker dissented -- again. The Richmond Fed chief has crashed the currency debasement party at every Fed meeting in 2012 with a lonesome (and likely unwelcome) dissenting vote. In fact, Lacker has now broken one Fed record and tied another: he is the first Fed president to dissent in more than half of his total votes.With December's vote, he has now tied the record for the most dissenting votes in a single year.

Despite the fact that, as ZeroHedge so aptly put it, Lacker's objections are generally "duly noted, and summarily rejected and forgotten" by his fellows, those of us searching high and low for evidence of sanity amongst monetary authorities now know where to find it: the Richmond Fed's website. There, under "press releases", you can read Lacker's comments on Fed policy.

After the announcement of QE3 in September, Lacker criticized the decision to purchase $40 billion of mortgage backed securities per month, noting that more asset purchases would not likely provide an appreciable boost to the economy but could indeed stoke inflation. Lacker also noted that the purchase of MBS represented an inappropriate effort on the part of the Fed to channel "the flow of credit to particular economic sectors." After Wednesday's FOMC meeting, Lacker rehashed and expanded upon his concerns before taking aim at the new addition to the Fed's statement: the explicit targeting of numerical thresholds.


Here's Lacker on inflation:

"With economic activity growing at a modest pace and inflation fluctuating close to 2 percent - the Committee's inflation goal - further monetary stimulus runs the risk of raising inflation and destabilizing inflation expectations."

Notice how Lacker seems to be reminding his colleagues that their inflation target is 2%. With all the talk about deflation and the absence of price increases, it is easy to get the impression these days that inflation is nonexistent, and as such, the Fed can keep on buying assets without fear of price destabilization. Consider for instance, the following quote from Chairman Bernanke from the press conference which followed the latest FOMC meeting:

"Meanwhile, apart from some temporary fluctuations, which have largely reflected swings in energy prices, inflation has remained tame, and appears to run at or below the FOMC's 2% objective in coming quarters and over the longer term."

What Lacker and other critics seem to be asking, is why-- if inflation is running at or around the target rate-- is there so little concern for the effect of the asset purchases on price stability? If one is pushing the acceptable limit, the best course of action might not be to push up on that limit as hard as possible until it is breached. More importantly, $2 trillion worth of asset purchases has produced only modest GDP growth and this sets up a potentially dangerous situation in terms of inflation.

Economic growth is creeping along somewhere at or below 2% and consensus expectations call for similarly disappointing growth in 2013. As I have noted previously, decreased government spending, constrained capex, and a consumer hobbled by miniscule interest income and stagnant real disposable personal incomes (not to mention stubbornly high unemployment) could mean GDP growth well below the historical average for quite some time. In fact, after running at or above 3% in every decade since 1950, U.S. economic growth averaged only 1.7% from 2000 to 2009 and has averaged only 2.1% from 2010 to the present. This is well worn territory but it needs to be repeated in order to set up a discussion about the link between asset purchases, meager GDP growth, and inflation.

Gluskin Sheff's David Rosenberg noted in late October that since 1945, the median growth rate for the U.S. economy in the thirteenth quarter following the end of a recession is around 5%. This is more than twice the current rate of growth. Meanwhile, the monetary base has exploded higher since 2008. In terms of inflation however, one may want to focus more on broader measures of money such as M2. As noted in an August 2011 blog post by John B. Taylor, the Stanford economist after whom the Taylor Rule is named,

"...Quantitative Easing has caused the monetary base-the sum of currency and bank reserves-to explode...but has not resulted in similarly large increases in the growth of broader measures of the money supply such as M2."

Taylor noted that the M2 multiplier had, through the Fall of 2011, decreased "in lock-step" with the increase in the monetary base. At the time however, M2 was moving rapidly higher leading Taylor to observe that

"...it's important to find out why [M2 growth has spike]. Is quantitative easing finally leading to a rapid increase in the supply of the broader money aggregates? If so, the Fed will need to be concerned about the ultimate effect on inflation, and perhaps start reducing the size of its balance sheet (and thus the monetary base) sooner than it would otherwise."

It would seem then, that if the M2 growth rate were to exceed the growth rate for the monetary base, it would be a sign that all of the excess reserves hoarded by banks were beginning to find their way into the system which could spark inflation. With this in mind, consider the following chart which shows the growth rate for the monetary base (orange) plotted against the M2 growth rate (blue):

Source: YCharts

As you can see, for only the second time since the financial crisis, the M2 growth rate has exceeded the growth rate for the monetary base and this time, the reversal has lasted far longer than it did at the end of 2010.

In order to avoid overstepping my own expertise and making claims which I cannot support without further research on the relationship between the different measures of money and the rate of inflation, allow me to move quickly to the overarching (and less debatable) point here. When the rate of growth in the various money aggregates exceeds the historical rate of growth while the economy grows at a pace which is below the historical rate of expansion, it would seem that, compared with the past, there will unquestionably be more money chasing fewer goods. In the words of Peak Prosperity's Chris Martenson,

"...the basic predicament here is that more and more money is being printed while the world economy, predictably for those who follow the net energy story, has been entirely stagnant and constantly threatening to slip back into economic retreat. Of course, more money + the same amount of (or even less) hard assets = the perfect recipe for inflation."

This is known as 'demand-pull inflation,' and it results from aggregate demand or, consumer demand, outpacing supply. One wonders if falling R&D expenditures, depressed capex, and falling productivity growth in conjunction with a Fed-induced increase in consumer credit could encourage just such a scenario.

Finally, it is worth noting that research by Milton Friedman (1972), Bernanke, Laubach, Mishkin, and Posen (1999), and Batini and Nelson (2002) all supports the contention that a significant time lag (perhaps two years) can be expected between policy actions and the peak effect of those actions on inflation. As such, it very well could be that the inflationary effects of the Fed's policies will not be felt for some time. As Bernanke himself noted in last Wednesday's press conference,

"Asset purchases are [not a] well understood tool...and we'll be learning in time what kind of unintended consequences they may create."

Ultimately, the best indication that inflation expectations are becoming unanchored is the fact that the Fed itself now says it is willing to tolerate inflation of up to 2.5%. Interestingly, this article itself confirms Dallas Fed Chief Richard Fisher's concerns that "the mere mention of a 2.5% target" will cause the market to become fixated on the number.

Presumably, Fisher understands that raising the acceptable level of inflation by a half percentage point while explicitly stating a numerical threshold for unemployment could indeed cause inflation expectations to become unanchored and could lead the public to doubt the Fed's commitment to price stability. In fact, one question posed to Bernanke during the post-statement press conference was:

"By [specifying] an unemployment rate that is quite low compared to currently, does that shift the balance of priorities in terms of your dual mandate...more in the direction of reducing unemployment rather than inflationary pressure?"

Along these lines, consider the following chart from UBS, which shows realised volatility in the 5 year/ 5 year breakeven rate:

Source: UBS, Bloomberg

In their words, the increased volatility indicates that,

"...that there are increasing doubts about the ability of central banks to keep inflation in check. [It] also suggests that credibility of central banks is eroded little by little as inflation expectations are less anchored than they used to be."

One can see then that there are quite a few reasons -- from considerations of the growth of the money supply in relation to GDP growth to concerns about the public's perception of where the Fed is now placing its priorities -- to believe that inflation may not remain subdued for long.

Blurring The Line

Jeffrey Lacker also suggested in his comments on the FOMC's latest policy statement, that the line between monetary policy and fiscal policy was beginning to disappear. As he did following September's Fed statement, Lacker referenced the committee's MBS purchases as evidence of an inappropriate step into the realm of fiscal policymaking:

"Deliberately tilting the flow of credit to one particular economic sector is an inappropriate role for the Federal Reserve. As stated in the Joint Statement of the Department of Treasury and the Federal Reserve on March 23, 2009, 'Government decisions to influence the allocation of credit are the province of the fiscal authorities.'"

While this is a valid point, the larger and more contentious issue is whether the Fed is facilitating government spending while disingenuously claiming that fiscal policymakers are demonstrating ineptitude by dragging the fiscal cliff negotiations into the eleventh hour.

As I have explained before, the idea that the Fed isn't funding the U.S. deficit relies on an absurd technicality. The claim is that when the Fed purchases Treasury bonds from primary dealers it is buying deficits of the past (i.e. existing bonds) and as such, it isn't encouraging government spending. This is so thinly veiled that I'm not sure any serious observer believes it.

The primary dealers of course, turn around and bid at auction for newly issued Treasury bonds with the money just handed them by the Fed, so there really is only one degree of separation between the Treasury selling government bonds directly to the central bank. Additionally, Bernanke claims that he isn't monetizing debt because the assets won't be held forever. Richard Fisher disputed this recently by noting that the Fed risks a "hotel California" monetary policy where it can technically check out, but can't ever leave.

It should also be understood that the Fed is propping up demand for Treasury bonds by creating a void on primary dealers' books which, in all likelihood, will be filled by the purchase of new Treasury bonds unless the dealers wish to meaningfully change the composition of their balance sheets after the Fed's purchases. This artificial demand drives down rates, effectively ensuring the government can borrow at rock bottom prices.

Another element in the equation is explained by PIMCO's Bill Gross:

"Basically, the Fed's policy has been...to write checks. Ben Bernanke, back in 2002, when he was the governor, basically told us in the first one or two pages of his scripted speech, he said that the quantitative maneuvers that he anticipated going forward were essentially costless. He is correct. What really happens is that the Treasury issues funds, the Fed buys them and then it remits interest to the Treasury quarterly or over time. It basically means that the Treasury is issuing debt for free."

Consider also that between its monthly Treasury and MBS purchases, the Fed is set to soak up 90% of all new dollar denominated fixed income assets issued in 2013.

Given this, is it really appropriate to say that the Fed isn't involved in fiscal policymaking? The central bank is after all, financing the deficit. Furthermore, is it fair for the Fed to claim that Washington should move faster on a fiscal cliff deal when the central bank is so transparently supporting runaway government spending and thus favoring one side of the aisle over the other? Add this to Lacker's concerns about the Fed dictating where the money flows and it really isn't clear what part of the economy isn't controlled by the FOMC.


There is a general consensus, exemplified by the "you can't fight the Fed" refrain, that as long as the Fed's balance sheet is behind the economy and is effectively propping up the financial system, that it is foolish to make bearish wagers. What I hope to demonstrate with this discussion and with many of my other articles is that far from making the system safer and immune to collapse, the Fed's maneuvers are making it more fragile than ever.

The entire system -- the stock market, the mortgage market, consumer spending, the bond market, the deficit, everything -- now depends on the flow of electronically created dollars into the coffers of the nation's top financial institutions. If anything destabilizes or interrupts this flow, the music will stop. Two familiar ways to profit from such a scenario are: a short position in U.S. Treasury bonds and an investment in gold or other hard assets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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