Should we be worried about inflation?

There is quite a bit of hubbub regarding inflation these days. Rightly so - the Gov’t and Federal Reserve’s response to the economic toll of the lockdowns last spring was unprecedented in size and scope.

Furthermore, inflation expectations will impact decision making for creditors, debtors, investors and households today and in the future. 

High inflation is good for debtors because debts held in an inflationary environment are paid back to the creditor with less purchasing power. The losers in a high inflation environment are the banks and savers, i.e. your Grandma holding her life savings in cash at the bank.

Quick Example:

A bank lends a homebuyer $100k @ 3% for 30 years today. Now let’s say inflation rises to 5% in the next few years. The bank is being paid back at 3%, but they have lost 5% in purchasing power. In real terms (after adjusting for inflation), the bank is losing 2% in purchasing power on this loan. 

The debtor or homebuyer is benefiting in this scenario. Assuming their income is rising in line with inflation, their purchasing power is growing because they locked in their debt at 3%. Meanwhile, they are receiving more in purchasing power over time as inflation rises.  

Of course, in a deflationary environment (the US has not seen this since the Great Depression), the creditor (lender or bank) benefits and the debtor (borrower) loses purchasing power. 

The last time we saw high inflation in America was in the 1970’s when inflation reached 13% after Nixon took us off of the Gold Standard. Interest rates rose as high as 20% to quell the inflation, causing all kinds of turmoil in the economy. 

In this article we'll first look at the Government and Federal Reserve response to the economic toll of Covid-19.

Then we’ll look into some data from similar actions taken in response to the Great Recession to see if if there are any clues for what we should expect this time. 

Fiscal Stimulus - $2.2 Trillion to Date

Fiscal Stimulus came via the $2.2 Trillion Dollar Care’s Act which was passed by Congress on March 27th. This spending primarily included $300B in direct cash payments to individual Americans, $260B in increased unemployment benefits, $350B in small business PPP loans (later increased to $669B), $500B in aid for large corporations, and $340B to state and local Governments. 

The fiscal package amounted to over 10% of US GDP and was significantly larger than the $831B package passed in response to the Great Recession in 2008-2009.  

Monetary Stimulus - $3 Trillion to Date

The Federal Reserve uses Monetary Policy to stimulate the economy and adhere to their mandate of stable prices and full employment. They typically do this by raising and lowering their interest rate target - the Federal Funds Rate. When the economy is running hot (employment is high and inflation is rising), the Fed will increase their interest rate target. This reduces the supply of money in the economy and raises interest rates. When the Fed is trying to stimulate the economy in a recession, they will cut the interest rate target. This adds liquidity to the banking system, increases the supply of dollars, and lowers interest rates. 

They accomplish this by buying and selling treasury bonds. When they buy bonds, they are adding liquidity to the banking sector and putting downward pressure on interest rates. When they sell bonds they are reducing liquidity in the banking sector and putting upward pressure on interest rates. These trades are happening with the Primary Dealer Banks - JP Morgan, Goldman Sachs, Barclays, Citi Bank, etc. 

The first move in response to Covid-19 by the Federal Reserve was to immediately cut the target Fed Funds Rate to zero as we can see in the chart below.

Source: Federal Reserve of St. Louis

However, when interest rates are at the zero bound, the power of “normal” monetary policy is quite stunted. They can lower their target Fed Funds Rate by providing liquidity to the banking sector, but if the banks are not lending due to economic uncertainty, then their action does not achieve the desired result. Ultimately the banks must lend into the economy for growth and economic expansion to occur.  Last weeks article looked at data revealing the banks are currently tightening lending standards at a level similar to the Great Recession.

This forces the Fed into an even more aggressive tactic they call Quantitative Easing. 

Quantitative Easing (QE)

What is QE? With QE, the Fed is monetizing the debt of the United States Treasury by providing liquidity to the banking sector and keeping interest rates at the zero bound.

The way that QE works is the Treasury issues United States debt through Treasury Bonds. These bonds are sold at auction to the Primary Dealer Banks. The banks then flip the bonds to the Fed, and the Fed gives them bank reserves in exchange for the bonds. The Fed is also buying Mortgage Backed Securities (at a lower rate) from the Primary Dealer Banks. This is how they monetize debt and how they “print” money. 

The net effect is that the Fed is accumulating assets on their balance sheet in the form of Treasury Bonds and the Primary Dealer Banks are accumulating bank reserve on their balance sheets. This is also pinning interest rates at zero.

In the below chart, we can see the impact to the Fed’s balance sheet since March.

Source: Federal Reserve of St. Louis. Annotated by Michael Nadeau

The Fed has purchased almost $3 Trillion in Treasuries and Mortgage Backed Securities in response to the pandemic and related economic shock.  

It is also worth noting that the Fed continues to purchase Treasuries and Mortgage Backed Securities at a clip of $120 billion/month (80/40 Bonds to MBS) with no end in sight currently.  

Ok, so now we understand why everyone is worried about inflation. It appears here that we have added $5 Trillion dollars to the economy. We certainly have not added $5 Trillion in more goods and services - in fact with GDP contracting, the opposite is true. It makes sense to think that we should expect inflation to rise.  

Let’s look at the data to see what’s happening. For the purpose of this analysis we’ll look at consumer price inflation (CPI). We can debate whether CPI is the best metric to track inflation, but it is the one that the Government uses so we’ll focus on CPI here. We can certainly have a separate discussion regarding inflation of asset prices in stocks and real estate. I’ll address that in a separate post.

We’ll start by looking at a chart of the assets held at the Federal Reserve going back to the Great Recession. 

Source: Federal Reserve of St. Louis. Annotated by Michael Nadeau

In response to the Great Recession in 2008, the Fed did QE1, QE2, and QE3. This expanded their balance sheet by about $3.7 Trillion.  

Now, let’s take a look at what is happening with CPI in the years after all of this QE.

Source: Federal Reserve of St. Louis. Annotated by Michael Nadeau

We can see in the chart that we have not seen any significant CPI inflation as a result of all of the QE that the Fed did from 2008 - 2013. 

Let’s take a look at the Velocity of Money over the same time span to see if there are any clues there.

Source: Federal Reserve of St. Louis. Annotated by Michael Nadeau

The velocity of money measures the rate at which money is exchanged in the economy. It is the number of times that money moves from one entity to another. Simply put, it is the rate at which consumers and businesses in an economy collectively spend money.  

Your expenses are someone else’s income. When you don’t spend, money is not moving in the economy which slows growth and dampens inflation. We are seeing this at historically low levels currently due to the economic toll of the pandemic. 

So what’s going on here? Why are we not seeing an increase in CPI? Where is all of the money going?

To understand this, we need to revisit how QE works. The Treasury is issuing Bonds and then auctioning those bonds to the Primary Dealer Banks. The banks then flip the bonds to the Fed and the Fed gives them bank reserves in return. The Fed is also purchasing Mortgage Backed Securities from the banks (at a lower rate than the Bond purchases).

Key Takeaway:

The Fed is adding liquidity to the banking sector via bank reserves and keeping interest rates low, but are the banks lending those reserves out into the economy? 

The below chart says that they are not lending those reserves. 

Source: Federal Reserve of St. Louis. Annotated by Michael Nadeau

This makes sense when we think about it. We can see that a similar trend played out in the Great Recession. Economic uncertainty is high. Interest rates are historically low. There are fears of inflation in the air. If you are a bank, would you want to lend right now? The risk is outweighing the reward.  

At the end of the day, the Fed can hit their interest rate target with QE and provide liquidity to the banking sector, but it is up to the banks to actually lend the dollars out into the economy. This is the precise point at which money actually gets out into the system and where growth in the economy occurs. 

Per the requirements of the Federal Reserve Act of 1913, banks can exchange the reserves they receive from the Fed with each other, with the Treasury, and with the Fed. They can also lend the reserves into the economy if they believe it is good for their business. They currently do not see it this way, and the Fed cannot force them to lend.

This is why we have not seen inflation from a CPI perspective.  

Conclusion

QE has historically not been inflationary in terms of CPI. That does not mean that it can’t be in the future. It could be, but for that to happen, the banks would need to be lending out all of these excess reserves they are receiving from the Fed. The data is telling us that is not happening currently and did not happen after the Great Recession.

Fiscal stimulus tends to be inflationary is short spurts that are more transitory in nature (lasting 6-9 months). We can see that in the CPI chart above. When Congress approved the Cares Act, money went out directly into individual and businesses hands. This essentially replaced a leaky bucket with liquidity, but it did not lead to any sustained higher level CPI. We can see in the chart the fiscal stimulus from March has already worn off as CPI is now steadily dropping.

What could cause high inflation going forward? As mentioned above, currently the Federal Reserve Act of 1913 restricts the Fed from sending money directly into the economy (like the Gov't Fiscal stimulus did). With that said, there are well known economists that believe it is possible that Congress will amend the Federal Reserve Act to allow the Fed to directly stimulate the economy. This would be the scenario of helicopter money being deployed directly to people and businesses. If this happens, it would likely come after a deflationary shock to the economy. This would be the “Crossing the Rubicon” move of last resort by the Fed and this would likely lead to high inflation almost immediately.  This is what Modern Monetary Theorists are advocating for.

Many believe that while QE is not showing up in higher consumer prices, it is artificially inflating stock and real estate prices. We’ll look into that in my next post. 

This analysis is provided for discussion and informational purposes only and does not constitute investment advice.  

Thanks for reading. Please let me know in the comments if you agree/disagree or have anything to add.