Inflation from Money Creation Isn't a Problem
A commonly expressed concern regarding the Federal Reserve's recent policy actions is by increasing money supply the Federal Reserve is stoking the fires of inflation once the recovery starts. This statement could be true in a limited set of circumstances. However, the far more probable scenario is the increased money supply will not lead to increased inflation. Let's look at the reasons why.
Before we move further there are two relevant points. The first is some of he information contained in this article is based on a booklet originally issued by the Chicago Federal Reserve titled, "Modern Money Mechanics." While it is no longer available from the Chicago Fed it is available by searching the Internet for the title "Modern Money Mechanics." Secondly, this article is a joint effort with a friend who -- for professional reasons -- must remain anonymous (various links refer to his pseudonymous work elsewhere).
First, let's look at the data of money supply to see what is actually happening. Here is a chart from the St. Louis Federal Reserve of M2:
This is in logarithmic scale with a circle around the last few years of activity. Notice how the recent money creation registers an increase, but not one of monumental proportions; it is hardly out of line with other increases that occurred over the last 30 years.
Secondly, let's take a look at the rate of change in the money supply:
This is the year over year rate of change in M2. Notice how the US experienced a higher year over year rate of change at the end of the early 1980s double dip recession and during the last recession. In other words, the current rate of growth in the money supply is hardly out of line with historical experience.
Finally there is the broadest measure of money supply M3. Unfortunately the government no longer maintains this monetary aggregate. However, Shadow Stats does. Here is their chart:
Notice how the rate of change has been decreasing since the beginning of 2008. Also notice that according to this chart, M1 has been increasing. However, remember that M2 and M3 each include M1 in their calculations. So the increase in M1 -- which is essentially physical currency -- is already factored into the M2 and M3 charts. The fact that M1 has been increasing indicates the Federal Reserve has been doing everything it can to get physical currency into the economy in order for people to spend it.
But just because the Federal Reserve is printing money does not mean we are spending it. The rate at which consumers spend their money is called velocity, which is "A term used to describe the rate at which money is exchanged from one transaction to another." Here is a chart of US monetary velocity:
The circle is around the latest time period. Notice how velocity -- the rate at which money goes through the economy -- has dropped at a sharp rate. This indicates that despite the increase in M1 (physical currency) people are spending it at a slower rate.
Let's tie this information into the official inflation rate. Here is a chart of velocity and CPI.
Above is a chart of velocity and CPI. Notice there are three periods. The first occurs from the end of 1959 to roughly the beginning of the 1990s. During this period velocity and inflation were highly correlated -- an increase in velocity meant an increase in inflation and a decrease in velocity meant a decrease in inflation. However, that relationship stopped for roughly 10 years from 1993 to 2003. The reason for this "decoupling" was the Internet/technology boom during that period. It allowed an increase in velocity to not have any impact on CPI. However, starting again in 2003 we see an a return to that correlation where an increase in velocity leads to an increase in inflation. That means that as velocity drops we are more likely to have a decrease in overall CPI -- which is demonstrated by the current chart.
Keep in mind the most fundamental definition of inflation: Too much money chasing too few goods. Now consider that the collective household balance sheet of America has shrunk over the last six quarters by some $13 trillion dollars, and will almost certainly decline further when the next Fed Flow of Funds report is released in a few weeks. (It is in this context -- the massive shrinkage of the American balance sheet -- that the Fed's money creation should be considered.) Keep in mind too the massive deleveraging that began last year and that will likely continue for some time to come. The San Francisco Fed highlighted this trend in a recent report. Ongoing changes in spending habits and attitudes toward credit itself are going to be secular -- not cyclical -- in nature. These are deflationary, not inflationary, changes (particularly in view of the fact that the U.S. consumer has been roughly 70 percent of GDP). There have been myriad stories written about the new "thrift" and "frugality" of the American consumer, and this change will be measured in years, not months or even quarters (this report foretold our Frugal Future). Hence these quotes from the most recent FOMC minutes: "Most participants expected inflation to remain subdued over the next few years, and they saw some risk that elevated unemployment and low capacity utilization could cause inflation to remain persistently below the rates that they judged as most consistent with sustainable economic growth and price stability." And this: "All [participants] anticipated that unemployment, though declining in coming years, would remain well above its longer-run sustainable rate at the end of 2011; most indicated they expected the economy to take five or six years to converge to a longer-run path characterized by a sustainable rate of output growth and by rates of unemployment and inflation consistent with the Federal Reserve's dual objectives, but several said full convergence would take longer."
Let's sum up so far. While M2 has increased in total and on a year over year basis, the increase is in line with historical experience. We saw a sharper increase in M2 at the end of the early 1980s and early 2000s recession. Finally, the direct relationship between and increase or decrease in velocity and inflation has returned along with a massive drop-off in velocity. This means we've seen a big drop-off in inflation.
Now, onto the issue of money creation. There has been a constant refrain that the Fed is printing money like there's no tomorrow. What these statements forget is they are temporary. Here's why. The Federal Reserve has essentially propped up most debt markets through their programs like the Commercial Paper Funding Facility, and the Term Asset Backed Securities Loan Facility along with several other programs. Through these facilities the Federal Reserve is essentially propping up several markets that were frozen because of the credit crisis. For those of you who are interested, the Wall Street Journal looks at the Fed's balance sheet every week.
These facilities create money. Here's how it works. When the Federal Reserve purchases a security it credits the seller's account. This increases the seller's reserves -- reserves against which he can now make loans and increase the money supply. However, let's remember an incredibly important -- and easily forgotten -- point. These Fed facilities are temporary; they will end one day. They started because of the Credit Crisis. As the credit crisis eases The Fed will start to sell these securities back to credit market participants As the do so they will "mop up" the excess reserves in the system. "Mopping up" means when Fed sells the securities to market participants the market participants will have to pay for the securities. That means the market participants will have to decrease their reserves, thereby lowering the amount of money they have available for loans, thereby shrinking the money supply. While it is true the Fed has never had to mop up as much liquidity as we have right now, that does not mean they can't do it. It simply means it will be a bigger job.
So to wrap up we have the following points.
1.) Absolute M2 is increasing but in line with current experience.
2.) The year over year percentage change increase in M2 is lower than the previous two recessions.
3.) M3 -- a larger monetary measure than M2 -- has actually decreased.
4.) Velocity is way down, indicating that the rate at which people spend money is decreasing at a fast rate.
5.) While the Fed has increased the monetary supply, they will mop up the excess liquidity as they wind down their programs -- all of which are temporary.
Simply put, monetary based inflation isn't a problem right now.
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I read the whole article to get to the truth of the article, contained in the last two words on the inflation problem " not RIGHT NOW.
Inflation worries are for tomorrow.
More confidence-building economic rhetoric.
With lots of data.
"Not to worry!".
We are on a private-banking, debt-money-fed intravenous life-support system, in the intensive-care-unit. As we check the vital signs, hey, things don't look too bad. Thanks for the update.
This unprecedented and massive infusion of new debt-money is keeping the debt-deflation, economic death-spiral at bay. For RIGHT NOW.
What happens during the contraction phase of backing-off all this money-creation?
The Modern Money Mechanics pamphlet (try to get one from the 70s) also covers the perils that we are facing in reversing this massive debt-moneyed cash infusion.
"There is one important difference between the expansion and contraction processes. When the Federal Reserve System adds to bank reserves, expansion of credit and deposits MAY take place ....
But when the System acts to reduce the amount of bank reserves, contraction of credit and deposits MUST take place to the point where the required ratio of reserves to deposits is restored." (my emphasis).
So, for every $1 of this new TRILLIONS of debt-money that the FED itself has expanded, when we get to the downlow cycle, $10 in loans must be canceled. OMG!
Or, not.
If not, inflation, plain as the nose on your face.
So for every dollar of debt money the fed expanded that is called back, the money supply will decrease $10? Sounds like the Fed has a way of controlling inflation for the next couple centuries.
Sorry I missed your reply.
The answer is that IF the Fed's monetary increase is used to increase the RESERVES of the banks that use that for lending, then YES, every dollar that comes out of those reserves on the way down reduces the allowed loans out there by $10.
Again, from the Fed's publication :
""But when the System acts to reduce the amount of bank reserves, contraction of credit and deposits MUST take place...""
And the question becomes, how does anyone control DEflation?
Both inflation and deflation are happening as well as stagflation. With no jobs being created in the short term consumer spending has decreased and will continue to. However, some services and commodities are no longer connected to supply and demand for "other" reasons. health care Ins. and services are decoupled as are Gasoline. Gasoline is part of the bubble economy and health care is now controlled by a few individuals at the top of the Health Ins. pile. The end result, massive poverty and dislocation for millions of Americans.
M1 is not the physical currency, M0 is (well almost). Classically, inflation has meant debasement of the currency--notes and coins. With no ability to distribute currency directly to the public (which would require a literal-not metaphorical--helicopter drop), the Fed has no chance of creating inflation in the classical sense. Granted, all modern economies support strictly fiat currencies, which makes it difficult to compare the current situation to that of the classical.
Inflation in the "classical sense" is the creation of money through expansion of credit. The Fed is just as capable (and even has as a goal) of creating inflation to promote growth.
I'm not sure what you mean exactly. Depositors can create credit by giving their money to bankers, who may then lend it. If you mean banks can create, in essence, bank deposits, that is an accepted argument, but it wouldn't be called "classical." That claim comes from the "Bank Deposit Theory of Prices." In order to accept this you have to misunderstand the difference between currency and money. The American public--they aren't alone in this--has had drilled into its head various notions of Monetarism. Claims of cause and effect were made between different levels of "money supply" and prices. If you're good at filtering data, you will be able "prove" this association.
By "classical" I was referring to the "Quantity Theory" of Money, which draws a relationship between currency and prices. Currency means coin and notes. You might not accept that as the classical view, in which case I'd be happy to know how the other view has deeper roots.
First inflation is being measured by increasingly disparate methodologies. There are so many politically motivated twists and turns in the algorithms used that the reported numbers are almost useless. Thus if you ask what is the rate of inflation I can say what do want it to be. Also, there are many transient factors at work at this time, some pulling in opposite directions. A year ago commodity inflation was rampant while wage inflation was stagnant. Commodity prices have stabilized and are increasing.
The Federal Government and the Federal Reserve are trying desperately to re-inflate the economy. There seems to be some notion that if housing prices are propped up at some artificial level all will be well and we can continue as before. Also, if raw money is added in any form to the economy it will turn around. These take the forms of money creation and deficit spending. These policies are already driving up interest rates and lowering the dollar as investors reevaluate our markets.
If unsuccessful the economy will continue slipping, debt will increase from faltering revenues and rising spending and we will only have the presses to fall back on. If successful the removal of excess money will require selling securities driving up interest rates and risking choking off recovery, which they are loath to do. Servicing the debt will be prohibitively expensive creating a logarithmic increase in debt or a huge tax increase or a huge cut in spending all choking off recovery.
Ole, in Calif. where we just defeated every thing Arnold put forward to raise income for our bankrupt state, the first and deepest cuts are coming in Education, Health, and social programs. Are we surprised?
My guess is that, even though it employs many state workers (or maybe because it does) the next round of cuts will be in infrastructure--highways, water, power etc.
They won't raise taxes, here or at the Federal level. Obama has already bailed on that. Which leaves us the Grover Norquist answer--destroy every support program put in place for the working people since 1933 in order to give the appearance of reigning in some govt spending without touching the defense budget. This does double duty by pushing working america to the precipice, while maintaining debt creation that feeds the banks.
Since this is and always has been a class war, our current economic "crisis"--manufactured right at the top--serves the interest of the oligarchs as they move forward with their creation of a Feudal State. Once we are sufficiently ground down, the debts that need to be forgiven will be, the currency will be revalued, if not replaced, the derivatives that are supposedly driving this nightmare will magically disappear by mutual consent of the parties that hold them who will all have been taken care of at the public trough to emerge stronger and more in control of our Country.
I posted this on the article about California's demise:
Years ago when the Navy was faced with a budget cut they cut the newest most powerful warship from their budget. A reporter noted that the yachts used by the Admirals were still tethered in their berths on the Potomac. Thus the muscle was being cut away to save the fat. These yachts were known as the Admirals' barges. So it will be in California. Firefighters, police, health care workers, teachers and all those who perform the necessary services will be put to the knife. Pork projects, administrators in redundant departments, meaningless studies and commissions and bureaucrats of every kind will be spared. It does not matter who is in office or what Party they belong, this is the nature of all large institutions whether Government or business. In business the executive perks, pay and bonuses are protected, everyone else is at risk including the shareholders.
Inflation: "Too much money chasing too few goods." Surely, we do not have this now.
We seem to have "debt destruction", which by it's very nature is deflationary.
Quite unfortunately, we have had severe inflation of those things that the population needs most to survive; food, energy and healthcare. There is no deflation there.
The Obama admin must ( they are working on it) changing the paradigm so that this is altered.
Inflation will become a phenomenon in China before it appears here again.
I think the focus on acceleration is well made. I find Hale's comments convincing. Acceleration is the key to growth in money supply, not actual dollars. Any school child knows that. With the innovative "financial weapons of mass destruction" having been turned into toxic assets instead of limitless accelerators of money supply, there is very little truly liquid money to float the economy compared to just before the collapse. Therefore, since with honest regulation and transparency, these weapons will be sheathed for quite some time, inflation should NOT be a problem for the foreseeable future.
The political landscape however is quite troubling.
This is reassuring. It does seem that we are in a deflationary environment.
Here is something that could use a little clarification:
Stagflation ---
On your "chart of velocity and CPI" , in contrast to the rest of the period from 1959 to the 1990s, velocity and CPI appear to be DE-coupled during the period from '75 to '80. That was the period of stagflation. We had serious inflation, but business was slow. During stagflation we were decoupled in a bad way, in contrast to being decoupled in a good way during the tech boom.
What was happening during that relatively short period of stagflation? It could be instructive for us now. It seemed like rampant inflation to those of us who were working back then.
Deflation, I believe, is the reason for the distortion in these numbers but I could not disagree with you more on the rest of your argument. Let me give you an example. When I was a child in the early 80s, I used to skateboard over to my local "Thrifty's" to get an ice cream cone. It cost 15 to 25 cents for a single cone and a half gallon cost between 99 cents to a $1.49. I have a family run WATER store in Avondale in the present day that sells the EXACT SAME "Thrifty's" ice cream made the same way it was during my childhood. It now costs $1.75 for the same cone and $7.99 for the same half gallon. What happened? The answer is INFLATIONARY MOENY CREATION. I have this same issue with people who talk about our incomes going up adjusted for inflation. This is a flat out lie! My current salary probably amounts to $6,000 to $8,000 in 2009 money where I would be making over $45,000 back in the 80s. INFLATIONARY MONEY CREATION caused this quick bubble in the economy which is now crashing down around us. The reason why deflation took hold is because supply has overwhelmed demand which is forcing a drop in prices. The American people don't have the financial tools anymore to maintain its spending spree so we are due for some extremely hard times ahead.
This song & dance may play in HEDGE FUND CONNECTICUT, but in the real world printing unlimited
amounts of fiat money without accountability or transparency , as well as other sleight of hand
maneuvers &, new word -MADOFFING just won't fly.
M3 is not decreasing; it just isn't increasing as fast as it used to. That's like saying spending $17 billion less than $3.5 trillion is a spending cut.
Because of the quantitative easing the Fed has taken, the inflation is evident in the lack of decrease in CPI. Your chart only has nominal change of CPI, not percentage change of CPI. Here is the real story: http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=CPIAUCNS&s[1][transformation]=pc1
Plus, M2 is still skyrocketing. If 5-7% of increase in a year in the M2 is only enough to get inflation up to -1%, then the deflation must be really low and there is a lot of inflation being created by the Fed.
the danger of inflation is not going to be classic definition of inflation as you have outlined. inflation is going to be a function of the value of the dollar as the reserve currency for the world. as the demand for dollar based transactions fall the VALUE of the dollar falls which will manifest in the dollar cost of all things rising.
I agree that all the information at present indicates no risk of inflation - if you insist on extrapolating from charts linearly into the future. We have by now all seen that this does not work in all cases. Once you let go of the charts, there is considerable risk of inflation, but whether it will be severe depends on policy decisions and those are hard to predict. Now, let us assume that policy will, as in the past, focus on the immediate gain. In a scenario with inflation raising its ugly head, this would mean that the gov., as well as big corporations will not stand in inflations' way: as far as they are indebted they profit from the devaluation of debt - and their income is far more flexible than that of the average person. Devaluation of the dollar, on the other hand, has already picked up, and foreign govs ponder to slowly abandon the dollar as a reserve currency. In addition, the fundamentals of the US as a manufacturing nation are not too good (and nothing else matters, however it is named, be it service economy, consumer driven economy or FIRE economy).
I read the first few paragraphs of your article, and then skipped the rest. No need to read it, or to even speculate about whether money creation will cause inflation. We can be 100% certain that it will, because in fact it's happening already. Gas in Los Angeles is up more than 10% just in the last month alone. It'll be above $4-5/gallon by the end of 2010, if not before, but it won't stop there.
"Simply put, monetary based inflation isn't a problem right now."
It might not be if you're a corporate millionaire, but if you work for a living it very, very definitely already is a severe problem. You need to get away from your fancy charts, Mr. Stewart, and talk to some real people who understand economics. You can't just generate income by printing money. If you do so it undermines the value of that money. This is basic economics, and a fact that has been proven hundreds of times in human history. It won't be any different this time.
thats not inflation with your gas, thats speculators driving the price of gas up, combined with memorial day driving and summer season and the switch to summer gas.
The most immediate impetus to inflation will be the fall of the dollar. How long will the central banks of Asia hold trillions in obligations of the U.S. Govt? This is it. When this happens you will see inflation and fed interest rate policy follow. When rates come up, the value of U.S. Govt obligations will fall in value increasing the liklihood they will be dumped onto the market. This also is a security issue of our nation that republicans painted us into. Trade deficits do count. And when interest rates do return to an historical real rate of 5% or so you'll see a general fall to the value of assets like homes(but with higher rates your payments will increase) and what impact that will have on rents remains to be seen (in the official cpi numbers you know the implied rents part)
Your assumptions about the potential for 'price' inflation resulting from the Fed's quantitative easing policies are categorically wrong.
The core issue that the markets are focusing on right now is the 'value' of the assets being exchange through the the various lending facilities that the Fed frantically set up to bail out bank's balance sheets as this crisis unfolded. If the value of those assets were one hundred cents on the dollar, the inflationary pressures of quantitative easing would be less severe. However, if those assets dumped into these lending facilities are in fact only worth thirty cents on the dollar, or ten cents, then you've got a gargantuan 'monetization' of bad assets that had been exchanged for US Treasury securities. THAT is where your potential for inflation lies - among other monetary missteps that the Fed is undertaking.
Listen to the markets, and listen to the foreign holders of US currency reserves and Treasury securities. They know all about the Fed using monetary inflation to 'pass the buck' onto other parties.
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