Inflation, Central Bank Independence, and a New Monetary Era
Since the beginning of the year, the Federal Reserve has poured over $2.9 trillion worth of freshly minted dollars (mostly using the 0’s and 1’s of a computer) into the U.S. economy. Inevitably, as soon as the Fed fires up the printing press, fear of inflation, loosely defined as a general rise in the prices of goods and services, creeps into the hearts of many.
Others immediately point to the Great Recession and the then unprecedented amounts of monetary stimulus in 2008–2014 and dire predictions of a second Zimbabwe that never materialized. Inflation sometimes seems like it belongs to a bygone era, but given the devastating effect it can have on unprepared investors, it is worth considering the matter more closely.
To better understand whether fears of inflation are justified, we must first understand what causes inflation and what role the money supply plays in the process. The remainder of this research note is structured as following:
- Part I discusses what causes sellers of goods and services to raise their prices.
- Part II discusses the relationship between the money supply and inflation, and why the dramatic steps the Fed took after 2008 didn’t ultimately lead to inflation.
- Part III discusses the new role the Fed is playing in purchasing government debt, a brief overview of Modern Monetary Theory (MMT), and how these trends could affect long term inflation.
Part I — What Causes Inflation
For inflation to happen, sellers of goods and services have to decide to raise prices. Since raising prices always causes buyer pushback, there are generally two reasons sellers would choose to do so: either their own costs are increasing — cost-push inflation — or sellers see very strong demand for their product — supply-pull inflation.
Cost-push inflation or rising production costs is the classic inflation story. As the economy heats up and unemployment decreases, sellers have to pay higher salaries, and thus must charge higher prices for their goods. Expecting prices to go up, job seekers demand ever higher salaries, which raises production costs, and thus expectations of inflation cause actual inflation.
Production costs can also increase because of shortages in capital or raw materials. This was the case in the 1970s when the oil crises drove up production costs, leading to a period of rising prices despite reducing production, also known as stagflation.
The other side of the inflation story is an increase in aggregate demand for goods and services by households, businesses, governments, and net exports. This could occur in an overheated economy, or because of a sudden increase in government spending. In a globally interconnected economy, fluctuations in exchange rates and diverging growth paths can also increase demand for net exports. Facing increasing demand, sellers decide it is worth raising prices.
In summary, inflation has to be caused by a mismatch between supply and demand that causes sellers to increase their prices. Increasing prices is unpopular and sellers will only do so if their prices increase, or if there is so much demand as to make price hikes worthwhile. But in between sellers and buyers is a medium of exchange, the currency, and it has the power to dominate mismatches of supply and demand.
Part II — “Inflation Is Always and Everywhere a Monetary Phenomenon” — Except When It Isn’t
The above quote from Milton Friedman embodies the essence of what economists refer to as the Quantity Theory of Money. The idea is that prices, and thus inflation, are determined by three forces: the amount of money in circulation, the velocity of money (the frequency of transactions in the economy), and the real value of the goods and services in the economy. The relationship between the supply of money and prices is a direct one — for a fixed amount of GDP, if the money supply increases then prices should go up. A decrease in GDP, which is when the Fed typically increases the money supply to spur growth, has a further inflationary effect, as more money is chasing fewer goods.
The Quantity Theory of Money suggests that if the Fed drastically increases the money supply while GDP is going down, we should see high levels of inflation. Following the 2008 Financial Crisis, the Fed poured $3.6 trillion, most famously through its government bond buying program known as Quantitative Easing. And yet, to the surprise of nearly everyone, inflation never arrived. Except for a hot second in late 2011, inflation never exceeded 3%.
Economists are still split over why increasing the money supply by 24.3% of GDP did not cause inflation, but the emerging consensus is that the majority of that money never made into the hands of consumers.
The traditional mechanism that central banks use to control the money supply is the interest rate they give commercial banks on their deposits. In the U.S. this is known as Federal Funds Rate. In theory, when commercial banks can borrow at lower rates, they can lend more money to households and businesses at lower rates. The central bank can also influence commercial bank lending by tightening or easing restrictions on the capital reserves commercial banks must keep on their books.
In effect, central banks do not control the money supply directly, but by proxy through commercial bank lending. Each dollar lent to commercial banks is levered many times over as the bank makes loans. But if commercial banks stop lending, as was the case after 2008, it doesn’t matter how low interest rates are, the money supply will not increase. Thus, the relation between the money supply and inflation is not directly in the hands of the Fed.
The second monetary tool that came into popular use by central banks following the Financial Crises is Quantitative Easing (QE). In an attempt to put even more cash into the system and lower long-term interest rates, central banks began to buy treasury bonds and mortgage-backed securities from commercial banks to the tune of $3.6 trillion. By creating demand for long-duration government bonds the Fed drove down long-term interest rates.
QE also put more money into the hands of commercial banks in return for the bonds they sold the Fed. In theory, this is money the banks could turn around and lend to the public. However, here again the Fed is dependent on banks’ willingness to lend. As Chart 3 demonstrates, household debt (including mortgages, credit card loans, etc.) did not return to its 2008 peak until 2016. Lending to corporations fared a bit better, but also did not fully recover until 2014.
The main reason that QE did not cause inflation is that most of that money never made it into the hands of those who would spend it. This means that there wasn’t enough demand to cause demand-pull inflation. Instead, the QE money was held by banks as reserves against the many toxic assets — mostly bad loans — they entered the crisis with. In practical terms, most of the QE money was used to bail out the financial industry from the crisis they created several years earlier.
QE trickled into the financial markets in other ways, namely by inflating asset prices of all types, though the mechanism here is less clear. In part, the Fed’s injection of money into the system creates a perception of growth, which in turn fuels actual growth as optimistic consumers and businesses spend money.
But there is also a more sinister mechanism at play here, namely corporate borrowing and stock buybacks. While corporate lending didn’t recover until 2014, it ultimately blew though the previous 2008 high of $1.6 trillion and by the end of 2019 reached $2.4 trillion. Of course some of this money was invested by businesses for growth in things like R&D, but much of this money was used to pay out dividends, and more concerning, for stock buybacks. The total amount spent by corporations on buybacks between 2008 and 2018 is estimated at $4.3 trillion.
Much has been said about the perils of buybacks — there are good reasons they were banned until legalized by the Reagan administration in 1982. But another outcome of buybacks is their contribution to wealth inequality. Namely, the wealthiest 10% of Americans hold 84% of all stocks. Unlike dividends, buybacks do not directly put capital in the hands of long-term holders of stocks such 401Ks and pension plans.
No conversation about inflation would be complete without mentioning the deflationary power of wealth concentration. Stock buybacks and debt-fueled stock markets are only one reason for the widening gap between the ultra-wealthy and the middle class. Other reasons include the devastation of home prices in the Great Recession, the key asset for middle income families, and changes in the workforce. Technology and the gig economy almost certainly also played a role. Whatever the reasons, the outcome cannot be disputed — the top 10% of wealthy Americans now hold 70% of all wealth, compared with 62.6% in 2000.
The mechanism tying income inequality to inflation is straightforward: wealthier families do not spend as much of their wealth on a percentage basis. If a middle income family gets $2,400 from the government, they are likely to spend more of that on goods and services than a wealthy family. The wealthy save a larger percentage of their assets, and these go back into the financial markets, further inflating asset prices but not the CPI.
In sum, the maxim that the supply of money is solely responsible for inflation does not survive contact with reality. It is not enough to increase the money supply; where the new money goes matters. Pumping trillions of dollars into the financial system may boost the economy without causing inflation, but as we all know, there’s no such thing as a free lunch.
Part III — The Dawn of a New Monetary Age
Quantitative Easing was always intended as a temporary measure that would help kickstart the economy. Central banks have dual mandates — keep unemployment low, and inflation within its target. That means that as the economy reaches full employment towards the end of the economic cycle, the central bank begins a monetary tightening to prevent cost-push inflation. Typically, this is done by raising interest rates, thereby making borrowing for individuals and corporations more expensive.
Monetary tightening is never politically popular, and many battles have raged between central banks and political leaders. But it is of the utmost importance in order to keep inflation in check. For this reason, legislation in most developed countries shields the central bank and its leadership from political interference.
The Fed started raising interest rates back in December 2015, but it wasn’t until 2018 that it started to unwind QE. This meant letting the bonds it was holding on its balance sheet mature, and perhaps even selling them in the open market. In turn, this would require the U.S. government to pay down some of its outstanding debt, or at the very least find new borrowers.
Not surprisingly, unwinding QE has the opposite effect of deploying QE. As can be seen in Chart 6, the stock market’s ascent stopped when news of the unwinding became public. President Trump, unhappy with this outcome, put immense pressure on Fed Chairman Jerome Powell to stop raising interest rates and restart QE. Ultimately, it appears that pressure worked.
In September 2019 the Fed began expanding its balance sheet. And while it insisted that this was an effort to stabilize financial markets and not economic stimulus, the outcome was the same and the stock market responded enthusiastically.
The Fed’s statements not withstanding, the bottom line is this: in the twelve years following the Great Recession, the Fed failed to shrink its balance sheet. With the economy at historically low unemployment, the Fed could not find a way, or was unwilling to bare the political price, of unwinding its allegedly temporary measure.
It is only fair to wonder why this is a problem. The Fed is a part of the U.S. government, so why should one part of the government pay back an outstanding loan to another part of the government?
This argument is most vocalized today by the proponents of Modern Monetary Theory (MMT). The theory suggests that in a modern economy, the notion of an independent central bank that controls the money supply is obsolete. Instead, the government can directly control the supply of money through its spending and taxation. In a recession, the government can cut taxes and increase spending by printing dollars — without borrowing from the public. As the economy reaches full employment the government can increase taxes and cut spending, and thus avoid demand-pull inflation.
In many ways MMT is the logical conclusion from a central bank that acts as a lender to the government, as it appears the Fed intends to do indefinitely. This is a sharp departure from the monetary policy that has governed developed economies for the past 40 years and was successful in taming inflation.
Put succinctly, the separation of fiscal policy from monetary policy is necessary for a stable economy. A pure MMT model requires politicians to strictly commit to spending money and cutting taxes only in bad times, and to increasing taxes and cutting spending in good times to avoid inflation. For an example of why this is a bad idea, look no further than the 2017 tax cuts — these are in direct contradiction with MMT’s suggestion that tax cuts take place only when unemployment is high.
While we are still far from a pure MMT model, permanent QE brings us closer to that reality. Unlike the QE that followed the Great Recession, it appears that much of this latest round has ended up in the hands of consumers and companies. There are a few reasons for this. For one, some of the QE money went directly to the Federal Government, who spent it on stimulus of various sorts including checks to individuals and the PPP program.
Another factor that could help the new QE money make it out to the public is the expansion of the program from treasuries to a wide range of fixed income securities, including bond ETFs and direct lending to companies.
Still, even if the entire $3 trillion ends up in the hands of consumers, it is doubtful whether it is alone enough to cause inflation. Federal Reserve data suggests that U.S. households lost nearly $6.5 trillion of net wealth in Q1 alone. With unemployment in the teens, household wealth is bound to stay depressed for some time. Consumer spending has already dropped by nearly half a trillion dollars since March, and that’s with one-time stimulus checks and increased unemployment benefits that end in July.
All this however does not mean that we are out of the woods. Following the Great Recession, QE lasted six years, with ever larger programs. While $3 trillion may not be enough to cause inflation, an increase of the money supply by two or three times that amount very well could, especially if consumption returns to pre-COVID levels.
Should the Fed continue to supply the U.S. government with money on demand, the damage to the Fed’s independence would be a blow to the U.S. economy and jeopardize the role of the dollar as the global currency. Fiat money is based on trust, and if people believe that the Fed is no longer willing to do what it takes to keep inflation at bay, that could spell trouble for the dollar.
It’s certainly too early to eulogize the greenback, but unlike other periods of inflation in recent history, today there are other major contenders for the role of the global currency, namely the Euro and Chinese Yuan, or maybe even some type of Blockchain hybrid.
For the stability of the U.S. economy and the global standing of the U.S., it is imperative that the Fed resumes its role as a non-political and independent player. With U.S. government debt on the rise, there will never be a good time to end QE. However, the Fed must start planning just such an unwinding of its balance sheet well before the end of this new economic cycle. If it fails to do so we risk not only high inflation, but a loss of the very tool that has allowed the U.S. economy to prosper.
— AD
