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The Reluctant Recovery: Part 2



This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the second in a series (see the first here). In this second part, the main focus is monetary policy. I argue that the Fed has correctly responded to the huge increase in the demand for safe-haven dollar liquidity that was caused by the Great Recession and the Eurozone debt crisis. However, the measures they have taken are so unprecedented and so potentially inflationary that they have introduced a significant amount of uncertainty to the market, and this in turn has contributed to the market being reluctant to believe that the current recovery is sustainable.


Quantitative easing has been accomplished so far by the Fed purchasing $1.6 trillion of Treasuries and MBS, in three stages. QE3 has only recently begun, and it is still relatively modest in size, with purchases scheduled to be about $40 billion per month. These purchases have been paid for not with cash, but with bank reserves. Since the Fed decided to pay interest on bank reserves early on in the quantitative easing process, bank reserves are functionally equivalent to T-bills since they are almost as risk-free and yield a little more (currently the Fed pays 0.25% on reserves, which is a bit more than the 0.09% yield on 3-mo. T-bills). This is very different from how things worked in the past, when reserves paid no interest and banks therefore had a strong incentive to use additional reserves to expand lending. In effect, the Fed has swapped $1.6 trillion of T-bill equivalents for $1.6 trillion of notes and bonds. The Fed has not "printed money" in massive quantities as so many have been led to believe. The Fed has merely supplied an asset to the market that was in very high demand (i.e., T-bill equivalents whose price was so high they yielded almost nothing) in exchange for an asset that was in less demand (i.e., notes and bonds with lower prices and higher yields). 


Quantitative easing was necessary to accommodate increased money demand. When analyzing monetary policy, it is critical to establish whether the Fed's willingness to supply money is greater, lesser, or equal to the world's demand for money. If money supply exceeds money demand, the result is inflation (e.g., too much money chasing too few goods and services). If money supply is less than money demand, the result is deflation (e.g., a shortage of money relative to goods and services). If supply and demand are in balance, the result is monetary nirvana—low and stable inflation. As the chart above shows, the demand for money (M2 is the best proxy for "money" that I am aware of, and comparing M2 to GDP is a good way to see how much money people want to hold relative to their incomes and their spending) skyrocketed beginning with the collapse of Lehman Bros. in late 2008. In effect, the world's demand for money soared; people wanted to save more, spend less, increase their cash balances, and reduce their debt.

In the chart above, the increase in the ratio of M2 to GDP from September '08 through today is the equivalent of approximately $1.5 trillion in additional M2 growth. It is not a coincidence that the world's extra demand for money, sparked by fears of a global financial collapse and/or a global economic meltdown, was of the same order of magnitude as the Fed's injection of $1.6 trillion of bank reserves. The Fed bought $1.6 trillion of notes and bonds and paid for them by crediting banks with bank reserves; a portion of those reserves were eventually exchanged for currency, which has increased by about $300 billion; about $100 billion of those reserves were used by banks to back up increased deposits; and the rest of the reserves found their way back to the banks, who were content to just hold on to them in the form of "excess reserves." Banks were risk-averse too, after all, and reserves were a safe asset that paid at least some interest.


Most M2 growth went to deposits. The chart above shows the different components of the M2 measure of money, with the largest by far being savings deposits. It is not a coincidence that savings deposits account for virtually all of the increase in M2 since the Lehman Bros. collapse. Savings deposits have increased by about $2.5 trillion over the past four years, with $1.5 trillion of that increase going towards satisfying the public's hugely increased demand for money. In short, all of the extra "money" that the Fed created in the form of bank reserves ended up in the banking system. It never made it into the economy.

  
Money growth has not been excessive by past standards. As the chart above shows, M2 in the past four years has grown only marginally faster than it has on average over the past 17 years. Accelerations and decelerations in M2 growth happen all the time, and the last two—driven by increased money demand—don't appear unusual at all. When inflation was rising in the 1970s, M2 growth was averaging close to 10% per year. M2 growth over the past four years has been an annualized 6.4%, and that is just not enough to fuel a significant rise in inflation.


Benign inflation confirms this. Both the headline and the core version of the Personal Consumption Deflator are within the Fed's target of 1-2%. Although inflation has been unusually volatile in the past decade or so, on average it has not been problematic. This strongly suggests that the Fed's efforts to expand the money supply have been matched by the market's increased demand for money. If the Fed had not launched Quantitative Easing, we would probably have seen deflation by now.



However, inflation expectations are rising. The above chart shows the forward-looking inflation expectations that are embedded in the pricing of TIPS and Treasuries. Inflation expectations have been rising in recent months, but they are still only moderately elevated compared to historical experience. I think this reflects emerging fears on the part of the bond market that the Fed is likely to make an inflation mistake in the future, and that is a very legitimate concern.


The dollar is extremely weak. The above chart shows the value of the dollar against large baskets of other currencies, adjusted for differences in the inflation rate between the U.S. and those other countries. It is arguably the best measure of the dollar's value vis a vis other currencies. That the dollar is very close to its all-time low suggests that the currency market also is feeling uneasy about the Fed's stewardship of the dollar. At the very least it suggests a serious lack of confidence in the future of the U.S. economy. The Fed may have done an excellent job accommodating the world's demand for safe-haven dollars to date, but in the process they may have undermined the world's confidence in the value of the dollar going forward.


Gold and commodities are very strong. Gold and commodity prices have risen significantly in the past 10 years, beginning with the Fed's initial efforts to ease in response to weak recovery that followed the 2001 recession. This is basically the flip side of the dollar's general weakness following its peak in 2002. The world's demand for dollars has been eclipsed by an increased demand for physical assets, which in turn is symptomatic of the beginnings of a rotation out of financial assets that could fuel future inflation. Recall that the sharp rise in inflation in the late 1970s followed a sharp rise in gold and commodity prices in the first half of the 1970s. Gold, which is up strongly relative to every currency, is sending a strong signal that the world is concerned that inflation is going to rise.

Inflation has not risen yet, but that is mainly due to the fact that the demand for dollars has been very strong, and that increased demand has been driven by fears, uncertainty, doubt, and a general lack of confidence in fiat currencies. If confidence in the future increases, the demand for dollars is likely to decline. Will the Fed be able to reverse its quantitative easing and/or increase the interest rate paid on reserves in a timely fashion, enough so as to prevent an excess of dollars—and a significant rise in inflation—from occurring? That is the biggest question lurking beneath the surface today. If the demand for M2 should decline, there is the potential for a $1.5 trillion—or more—excess of dollars to develop. Looked at another way, there is $1.5 trillion sitting in bank savings deposits that could be spent, and banks' excess reserves could be used to make new loans and expand the money supply almost without limit. If the world just attempted to reduce its holdings of savings, $1.5 trillion could find its way into higher prices for goods and services, and that could fuel some significant inflation, and perhaps some additional growth, in the years to come.

In short, it's understandable that markets are reluctant to believe that things will continue to improve.

Next installment: fiscal policy

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