Why is US Inflation Low?-VRK100-04Oct2013

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One question that tickled my mind in recent months was why the US inflation is low even though the US Federal Reserve has flooded its economy with fiat money. I’m no expert on economics. Nor do I have any great understanding of the dynamics of the US economy. Anyway, let me make an attempt.

What is Inflation?

Inflation rates go up when prices go up. Too many dollars are chasing lesser quantity of goods and services pushing up their prices. As prices rise, the value of your money falls. One of the key factors influencing inflation is money supply (See notes 2 to 8 below). Other factors could be expectations, fiscal deficit, economic activity, investment by firms, wages and others.

“Inflation in a fiat money world is difficult to suppress,” opined Alan Greenspan, the former chair of the US Fed. Fiat money or fiat currency is simply paper money printed by a central bank on behalf of a government and released to the economy. One important feature of fiat money is that the governments have enormous power to create or destroy this paper money. For several decades though, the world has been experiencing a very large creation of paper money, but not its destruction.

The dynamics of the world economy have changed enormously and in several ways in the last two to three decades. Inflation has, more or less, remained low in many advanced economies, like, the US, the UK and the eurozone countries. For over two decades, Japan has suffered deflation—decrease in price levels. In the last six months or so, the Asian giant seems to be coming out of deflationary trends after Japan decided to double its monetary base.

The Standard Medicine in the US:

What does the US Fed do in order to stimulate a weak economy? In normal times, the Fed eases monetary policy by lowering its target for the short-term policy interest rate, the federal funds rate. And to tame inflationary pressures, the Fed raises short-term interest rates, which makes the money costlier to borrow. This is the standard medicine.

The US has zero-bound interest rates (federal funds rate of 0 to 0.25 percent) since December 2008. Theoretically, the record-low interest rates would have stimulated credit growth and resulted in a gradual increase in inflation. But none of this has happened in the US in the last five years since the global financial crisis.

Inflation is always and everywhere a monetary phenomenon, said noted economist Milton Friedman. His argument was that to contain inflationary pressures, you’ve to first restrain the money supply. However, using this tool to control inflation is considered blunt. Interestingly, the importance of money supply in stoking or subduing inflationary pressures has diminished in the US in the recent past (See notes 7 and 8 below).

After the 2007/2008 global financial crisis, the Fed has been trying to stimulate the US economy with its easy money policy. As part of the quantitative easing (QE) program, the Fed has been buying bonds as it cannot lower its interest rates below the present 0 to 0.25 percent. As a result of the unconventional QE program, the monetary base in the US has gone up by almost four times in the last six years or so.

Related: What are Fed Tapering and Quantitative Easing? 19Sep2013

But the US inflation rate has been at an annual average of around 1.5 percent in the past five years. When the monetary base has gone up four times and the interest rates have been kept close to zero percent in the last five years, why is that the US inflation rate has been below the US Fed’s comfort level of two percent?

The Answer is:

1. The money pumped in by the US Fed has reached banks. But the banks are holding the funds as excess reserves, instead of lending them; and these reserves are again kept with the Fed! Of late, the Fed has been paying interest on these reserves to banks and other financial institutions.

So, the banks find it more attractive to receive interest from the Fed rather than lend to households or businesses. The lending is not happening as the economy is weak. It’s no surprise that the growth in the US national income too is below two percent in recent years and unemployment rate continues to be at more than 7 percent.

2. The US households’ savings rate was close to zero percent prior to 2008, but now it’s anemic at around three to four percent of GDP. Household debt was very high prior to 2008. After the global financial crisis, wage incomes are down for many millions of US citizens.

They want to save more rather than spend their money. The US households have been focused on reducing their debt, rather than increasing personal consumption. Consumer consumption growth is a dominant factor in the US economy. Of late, consumer consumption growth too is anemic at less than two percent. So, the deleveraging continues in the US economy resulting in low inflation, while the unemployment rate continues to remain at elevated levels.

3. The balance sheets of many US companies are very healthy and they are awash with liquid money. As they aren’t sure about the prospects of US economy, they’ve been using their excess cash to repurchase (buyback) shares rather than invest in new plant and machinery or creating new jobs.

The tech-giant Microsoft has announced a $40-billion share buyback recently. The company has increased its dividend also. Companies, like, Apple, Merck, GE, Home Depot, Time Warner and 3M, too have offered/undertaken share buybacks in the past six months to one year.

Relation between money supply and inflation becomes tenuous now:

Evidence in the past indicated that there was a strong connection between money supply and inflation rates. But history need not repeat itself. This strong connection becomes tenuous now, at least in the US. (See notes 7 and 8 below).

The US Fed has been preparing the world markets for unwinding of its asset purchases, by floating “balloons” since May this year, when they first talked about tapering. When the markets reacted violently—after the talk of tapering started— resulting in the steep decline in prices of bonds, shares, commodities and large scale outflow of funds from the emerging markets; the Fed, the ECB and the IMF tried to assuage the markets by communicating that they would continue their easy money policies as long as the economic growth remains weak.

At the same time, the Fed wants the unwinding of highly risky and levered positions in the markets. (It may be recalled the easy money available in the US and other nations moved to commodities and non-US markets, especially emerging markets, for achieving higher yields).

Between May and the middle of September this year, many such highly levered positions have already been unwound. Now that the markets have already experienced this fall due to talk of tapering; the market’s future reaction may be muted once the Fed starts actual tapering of its bond buying program.

Finally:

It is inevitable that the US interest rates have to go up one day. It won’t be a surprise if the inflation rises in the next 12 to 18 months above the US Fed’s comfortable level of two percent. The world is deluged with dollars printed by the US Fed. Investors have borrowed money at lower rates in the US and invested the money in emerging markets and others in their quest for higher yields. As we have seen in the last four months, the unwinding of levered bets has created problems not only for the emerging economies, such as, India and Indonesia (See note 9 below); but also to investors themselves.  

The US banks have to start lending their excess reserves once the US economy picks up momentum and the demand for money grows. The concerns that the inflation in the US and other developed world will rear its head once again are genuine.

Related:

What is US government shutdown and debt ceiling limit? 27Sep2013

Emerging markets down but not out 10Aug2013

References: US Fed FAQs; “The Age of Turbulence” by Alan Greenspan

Photos above are courtesy of US Fed. Left is Marriner S Eccles Bldg of the Fed and right is Fed board room.

Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions.

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Notes:

1. The US Federal Reserve (US Fed) is the central bank of the US

2. Money supply: It is a group of assets that households and business can use to make payments and to hold as short-term investments. One way to calculate money supply in the US is to aggregate currency and balances held in checking accounts and savings accounts.

3. Monetary base, M1 and M2 are various ways to measure money supply.

4. Monetary base: It is the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the US Fed).

5. M1: It is the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions that obtain their funds mainly through deposits from the public, such as commercial banks, savings and loan associations, savings banks, and credit unions). 

6. M2: is defined as M1 plus savings deposits, small-denomination time deposits (those issued in amounts of less than $100,000), and retail money market mutual fund shares.

7. For several decades in the past, central banks including the US Fed used these measures of the money supply as an important guide for conducting its monetary policy because these measures used to have fairly close relationships with other factors such as, gross domestic product (GDP) and price level. Based partly on these relationships, some economists—like Milton Friedman—argued that the money supply provided important information about the near-term course for the economy and determines the level of prices and inflation in the long run.

8. However, these relationships between the money supply measures and GDP and inflation in the US have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time. The Fed regularly reviews money supply data in conducting monetary policy, but money supply figures are just part of a variety of data points it takes into account.

9. Fragile Five: Morgan Stanley described five countries—Brazil, India, Indonesia, South Africa and Turkey—as the “Fragile Five.” These countries are facing outflow of funds due to the fear of US Fed tapering. More over, these nations are experiencing severe current account deficits and political risk. All these nations are going to the polls next year and investors are focusing too much on political risk in these countries.

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