For Sepetmber 2008, the monetary base was reported at $903.5 billion. For October, it was reported at $1.1285 trillion. That's an increase of $225 billion. That's how much money the Fed created directly in one month. A couple of months of that would be enough to finance last year's federal deficit. Three or four months would be enough to finance this year's likely deficit, including the first half of the TARP.
Granted, not all the money was actually used to finance the federal deficit. Much of it was used for even more "inflationary" purposes, such as emergency lending to banks. But the money was created, and it could have been used to finance the federal deficit. And if the Fed keeps creating money at anywhere near that rate, chances are that the portion created by buying T-bills and other Treasury securities will be enough to finance the current deficit, even if that deficit is larger than we expect.
And yet not many people seem to be worried about inflation. TIPS are selling at historically high yields relative to nominal Treasuries. Commodity prices are crashing. And the great debate of the time is about whether we will experience deflation.
Yes, Virginia, there is...
But don't "long and variable lags" say that inflation (dare I say, hyperinflation) will hit in late 2009, early 2010 or so?
ReplyDeleteI'm skeptical of the "long and variable lags" theory in this context. Not that I don't agree that the lags in the impact of monetary policy are indeed long and variable. But in this situation, I don't think monetary policy is necessarily effective, even with a lag.
ReplyDeleteIt's easy for me to imagine a situation where the Fed keeps creating a lot of money for a long time, and it has no effect. If the Fed is just creating money by buying T-bills, and the yield on T-bills is approximately zero, then they're just replacing one asset with a roughly equivalent asset. As long as the demand for safe assets remains high enough to keep the T-bill rate near zero, there's pretty much no limit to the amount of money the Fed can create, and I don't see why it would have any impact, with or without a lag.
There is the point, however, that one does hope for an eventual recovery, and when that happens, the demand for safe assets may go down, and the Fed may be forced to withdraw much of the money it created, so you can have a "reverse seignorage" situation. I'm not aware of what the evidence is on this point, but my offhand guess is that this would not happen; instead, the recovery would be slow enough that the Fed would only have to slow down the creation of money and not actually withdraw money.
I think most of the evidence regarding the "long and variable lags" (and the inevitable ultimate effectiveness of monetary policy) comes from data where money creation was taking place passively, and the conventional interpretation is mistaking an endogenous variable for a causal one. That is, prior to a boom, we are likely to see increases in the demand for money, which show up as increases in the quantity. Then once the boom happens it starts to create inflation.
>> Then once the boom happens it starts to create inflation.
ReplyDeleteDo you need a boom to get inflation? Most "great inflations" occur in an environment of stagnating economic activity (see latin america, see eastern europe, see weimar, etc.) But clearly, if they keep printing money as they are now, inflation will rear its ugly face. How much money you need is besides the point -- print enough, you will get inflation regardless of the level of economic activity.
What is the mechanism that sees this happen? I am not sure I know. I do know, however, that it does happen. And that we appear to be on that trajectory. Thoughts?
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You don't need either a boom or a growing money supply to create inflation. It can happen spontaneously, if people lose confidence in the value of money, even if the money supply remains constant.
ReplyDeleteAnd the converse is also true: printing money does not necessarily cause inflation, if there is sufficient confidence in the value of money. In Japan, people had so much confidence in the value of yen that the BoJ was able to create huge amounts of yen, and still there was no inflation.
If you tell people that creating money causes inflation, and they believe you, and they see that the money supply is rising, then there will be inflation. But they won't necessarily believe you. In Japan, they didn't. Especially since I have that counterexample, I'm not impressed by the self-fulfilling prophecy that printing money causes inflation.
In unstable places where people don't trust the government, and where the currency is not widely used in international exchange, and where many of the debts are denominated in foreign currency (for all of these conditions, see Latin America, see Eastern Europe, see Weimar, etc.), it is easy for people to lose confidence in the value of money, especially if they see a lot of it being created.
In a place like the US (or Japan or the Eurozone) people typically won't lose confidence in the value of money until they actually observe its value declining (see the 1970's), and the cause of that initial decline in value is usually a boom (see the late 1960s and the early 1970s).
>> In Japan, people had so much confidence in the value of yen that the BoJ was able to create huge amounts of yen, and still there was no inflation.
ReplyDeleteYeah, it is the Japanese model that is driving markets right now, eh? My best guess as to why the Japanese printed mountains of yen and did not suffer inflation is because the Japanese debt was *largely* self-funded. Japanese households were rich and saved a lot while Japanese businesses ran large trade surpluses. This activity funded government prolifigacy. The situation in the US is now very, very different.
>> In a place like the US (or Japan or the Eurozone) people typically won't lose confidence in the value of money until they actually observe its value declining (see the 1970's), and the cause of that initial decline in value is usually a boom (see the late 1960s and the early 1970s).
Well, some would argue that the inflation of the 70's was caused by fiscal excess, and the loose monetary policies of the 60's. Of course, economic activity accompanied such excess, but it was the come-hither approach to money that in the end lit the inflationary fires.
Which gets me back to *why* inflation starts? Surely it is a confidence thing. But is also a monetary thing. How are the two related? I see economic activity declining in the States for years to come. I also see inflation going triple digits. There are just too many historical data points to avoid the fate. The mechanism from A to B is not as clear.
Japanese households were rich and saved a lot while Japanese businesses ran large trade surpluses. This activity funded government prolifigacy. The situation in the US is now very, very different.
ReplyDeleteWell, not necessarily. If this recession does prove intractible, it will be for one of two reasons: either households and businesses are saving too much, or the dollar is overvalued relative to what would balance our trade payments. There really is no other way: if there isn't enough demand to utilize all the country's resources, it's either because people are not consuming enough, because businesses are not investing enough, or because we're importing too much relative to what we export, and the last of these won't happen unless the dollar is overvalued. Either we are as frugal as the Japanese, or the world has tremendous confidence in the dollar despite our profligacy. Either way, no hyperinflation. Unless you think that the foreigners are a bunch of dupes who are too gullible not to buy our currency but will eventually wise up. I guess that's a possibility.
Anyhow, I don't know how you can say "there are just too many historical data points" when the latest data point from a nation comparable in advancement to US goes the other way.
Which gets me back to *why* inflation starts? Surely it is a confidence thing. But is also a monetary thing. How are the two related?
They are related via the money demand function. Here's one way to look at it: money demand depends on confidence, and the value of money depends on supply and demand. So if the Fed expands the money supply enough, it will move along the demand curve to the point where it is trying to "sell money" to people who have little confidence and therefore won't pay much for the money, and the value of it goes down.
But now, I'm arguing, the confident people (that is, people who have no confidence in anything except money) have such an appetite for money that the Fed can sell them huge amounts of it before it has to try and sell any to the less confident people, so the value stays high, even rises, until the confident people start to become less confident (which is to say, they start to become confident in something besides money).
Of course if people become too unconfident, the Fed can always soak up all the money it has created before it has a chance to cause much inflation. One thing about the long and variable lags is that they are cumulative. If you have a big upward spike in the money supply followed by a downward spike, you can have a longer lag on the up spike and a shorter lag on the down spike, and they can cancel out. The point is, something has to happen on the way from money supply increases to inflation. Either the money supply increases causes a boom, so people start demanding more goods, and the prices go up (a pretty good description of the Arthur Burns episode: Nixon wanted a boom, and Burns gave it to him, and it was followed by inflation). Or else people notice the money supply increases and lose confidence in money.
Although I have to think about this a bit more before I can tell a coherent story that takes into account both the money demand function and the Phillips curve. Part of confidence in money is whether people are willing to accept it in exchange for other financial assets, and part is whether they are willing to accept it in exchange for goods and services. But the latter is complicated: people may be willing to accept money just because they're desperate for any kind of payment (a depression), or they may be unwilling to accept it just because they have a higher bidder (a boom).
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I don't agree that the lags in the impact of monetary policy are indeed long and variable. But in this situation, I don't think monetary policy is necessarily effective, even with a lag.
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