7 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff discusses the technical mechanics of inflation and deep-dives into what’s really behind today’s accelerating price increases.
|Federal Reserve Chairman Jerome Powell|
In this column the Economics Correspondent will use a bit of technical terminology to save space. To review the definition of these terms feel free to go back to his early 2020 eggheady articles explaining:
1) Federal Reserve operations and policy tools
2) A primer on inflation and the Equation of Exchange
3) Is runaway inflation inevitable?
It's good stuff for anyone wanting to understand the U.S. monetary system and inflation anyway.
In the meantime, let’s start going back to the onset of the Covid crisis and revisit how we got to today’s growing inflation problem.
WHY LITTLE INFLATION IN 2020?
In March of 2020 the Federal Reserve embarked on an unprecedented quantitative easing campaign in response to a growing Covid crisis—both from hard government lockdowns and the virus itself.
The FOMC restarted its large-scale asset purchase program, increasing the monetary base by 77% from $3.454 trillion in March 2020 to $6.130 trillion today. It achieved this by buying a combined $2.2 trillion in U.S. Treasury and government-backed mortgage securities with freshly printed bank reserves.
What made the 2020 QE truly unprecedented was, unlike in 2008 when the Fed paid banks risk-free, zero-maturity interest on excess reserves (IOER) to discourage them from lending too much, the Jerome Powell Fed actually encouraged aggressive lending of new reserves by lowering bank reserve ratio requirements to zero and reducing the IOER rate to a range between zero and 0.15%.
In other words, unlike during the 2008 financial crisis, the Fed *wanted* the commercial banking system to create trillions of dollars in new Main Street money.
And create they did. From March 2020 to today the M2 money supply rose by 33% or over $5 trillion. The M1 money supply rose much faster, by 24% in only the first three months of QE before the Fed changed the definition of M1 to include most M2 components, making the jump look less dramatic (the Economics Correspondent thinks the timing was not a coincidence).
But the Fed did *not* want price inflation, only more money.
Which leads to a logical question: how can a central bank seek to deliberately raise a broad money supply aggregate by 33% but simultaneously seek not to raise prices? Can they actually square this circle?
Yes. As the century-plus old monetary Equation of Exchange informs us…
mv = py
…(p): prices move proportionally to the (m): money supply (more money = higher prices) and inversely to (y): economic output (more goods = lower prices).
During the 2020 lockdowns money grew rapidly and output plunged. So simple math would suggest we should have seen skyrocketing prices—in the range of 45% inflation in just three months.
But we didn’t. Prices were actually flat to slightly down in the second quarter of 2020. Why?
Because the last variable of the Equation of Exchange, (v): velocity, plunged and offset the other two. In fact, velocity plummeted by a new record of its own: down 26.5% in a single quarter. For this reason the Economics Correspondent wrote in 2020 that predictions of imminent hyperinflation were unlikely.
To the Fed’s credit, it had anticipated all this from the beginning, and why not? When an economy is placed in a coma, businesses are shut down, workers lose their jobs and income, and even employed workers cut back on spending due to uncertainty, velocity is going to collapse.
And the Fed knew it. Hence in March of 2020 it deliberately ballooned the money supply to prevent prices from falling 26.5% in a single quarter as well, and it did a good job of keeping overall prices remarkably steady even as the monetary variables gyrated wildly.
The Economics Correspondent is not a fan of the Federal Reserve but feels the central bank deserves credit for its actions in 2020.
2021 has been a different story.
WHAT HAPPENS IN RECOVERY?
However in the summer of 2020 the Economics Correspondent posed a question about the greatest inflation risk on the 2021 horizon: What happens when the economy recovers and velocity rises?
All the new money will still be out there but the rate at which it changes hands will increase too, hence creating inflationary pressures.
At the time the Correspondent mentioned three possible factors that could offset rapidly rising prices, two of which are under the Fed’s control.
1) Slow or stop the asset purchases, or in an extreme case sell assets in open market operations to contract the monetary base. If prices start rising too fast there’s no more reason to keep blowing up the monetary base and encouraging banks to keep creating new money.
2) Raise the banks’ reserve ratio or, more importantly, the IOER rate to discourage too much lending.
3) A rebound in GDP growth, more real goods and services, could partially offset increases in velocity. This is the one factor largely outside the Fed’s control.
So far the Federal Reserve has not reported on monetary velocity since April, 2021 and the Correspondent believes we will see an uptick when the late summer’s numbers are finally published. Even a 3% increase in velocity, when paired with all the new money being printed, can easily push prices up by 5+% on an annualized basis.
Well it’s now the fall of 2021 and everywhere we are seeing price hikes accelerating. In one of the most extreme examples of an alarm bell, the Bureau of Labor Services reported “For the 12 months ended in August, the index for processed goods for intermediate demand climbed 23.0%, the largest 12-month increase since jumping 23.6% in February 1975." (see BLS release)
DO WE HAVE THE RIGHT MONETARY POLICY NOW?
With all these alarm bells ringing, has the Fed cut back on asset purchases or raised reserve ratios or the IOER rate?
Nope, the Fed continues to encourage new money creation and, in the Economics Correspondent’s opinion, has absolutely zero excuse for continuing to buy mortgage-backed securities. The original justification was to support the housing market, but housing is now entering bubble territory, needs no support whatsoever, and yet the FOMC is continuing to push mortgage rates down and home prices up.
The Fed has the power to moderate the inflation right now, but so far hasn’t lifted a finger to do so. Instead it has changed its official inflation target from “2% per year” to “an average of 2% over many, many years” allowing it to justify a current inflation rate greater than 2%.
So far the only thing the Fed has done is speculate whether or not it will “taper” later this year or slow down the rate of, but not stop, asset purchases. However it plans to keep zero reserve ratios and near-zero IOER interest payments.
In a September 2020 column the Economics Correspondent worried that if inflation did pick up the Fed would drag its feet and deliver political excuse after excuse for acting slowly to, in his opinion, help reduce the Treasury’s real burden of paying down the ballooning national debt with higher inflation for as long as is politically palatable.
With a current national debt of $26.7 trillion, if the Fed can maintain 5% inflation for just one year it effectively eliminates $1.34 trillion of the government’s debt without the Treasury paying a penny.
The Economics Correspondent also thinks this timing is no coincidence either. The federal debt-to-GDP ratio eclipsed the old record of 120% going back to 1945—last summer. In another incredible coincidence the Fed also cut off that chart on its website last year so viewers can only go back to 1966.
Incidentally, scapegoating of “supply chain problems” and “transitory inflation” don’t fly with economists who really understand what really causes inflation (read the Economics Correspondent’s inflation fallacies columns to learn more).
Besides, a lumber shortage here replaced by a chip shortage there doesn’t create the widespread price pressures we’re now seeing in nearly all sectors. Too much money and too much velocity does.
THE LAST CULPRIT
And even with the Fed slow to act, there’s another, secondary party responsible for inflation: Biden and the Democratic Congress. When prices begin rising rapidly, one thing the legislative and executive branches can do is slow down their rate of spending, thus slowing velocity.
But as we all know, they are not only continuing to borrow and spend like mad, the House and Senate are working on a new $3.5 trillion “infrastructure” spending package loaded with more pork than the country has ever seen.
Also adding to the problem, thankfully soon to end, has been extended generous unemployment benefits particularly in blue states.
The borrowing or hundreds of billions of dollars to hand out to states for generous unemployment payments keeps velocity up (when jobless workers spend the benefits) but does nothing to increase output since workers are being paid to stay at home. Hence more velocity + unchanged output = more inflation.
Granted the biggest driver of inflation is still the Fed, but the Democratic executive and legislature are pouring fuel on the fire at precisely the wrong time.
Yet now Democratic politicians have started resorting to the timeless inflation scapegoating done by bureaucrats for centuries. Biden’s Agriculture Secretary has blamed “price gouging” for inflation instead of its true causes: more money, more government spending which means more velocity, and paying people to produce less.
In conclusion, inflationary pressures are no surprise given rising monetary velocity in an economic recovery. And the two institutions that are most contributing to rising prices, the Federal Reserve first and foremost and then the federal government, have the power to restrain inflation.
However so far neither has shown a willingness to act. The Fed continues to engage in large-scale asset purchases, continues to inflate a housing bubble by buying mortgage securities, and continues to encourage bank lending of new reserves into the real economy via zero reserve ratios and a near zero IOER policy rate. The most it’s done to restrain inflation is speculate that it might “taper” later in the year or slow, but not stop, its asset purchases.
Congress and the Biden White House, at a time when the federal government needs to restrain its spending like no time since the late 1970’s, is working on packages to borrow and spend unprecedented trillions more on “infrastructure” programs at precisely the worst time, and until recently was borrowing and spending more on paying people not to produce.