Economics and Inflation: A puzzle

January 6, 2010

The monetary base is exploding, but so far Wall Street is betting against a resurgence of inflation.  The consensus seems to be that banks are sitting on their new reserves instead of lending, and the Fed can remove that cash from circulation at the right time and avoid inflation.

One of our favorite sources on economic thinking is Greg Mankiw’s blog.  Professor Mankiw (of Harvard) recently argued that when banks’ reserves earn risk-free interest, they’re virtually identical to Treasurys, and so the monetary base as a statistic loses its predictive value.  The issue for Mankiw isn’t technical, but the time-honored political one:  will the Fed have enough strength and independence to do the right thing and “take away the punch bowl” at the right time.

Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University and author of this article on inflation in Reason,  responds to Mankiw here.  She counters that it would indeed be a remarkable achievement if the Fed had discovered a new method to increase the money supply without creating inflation; instead it is more likely to have simply replaced one asset bubble (housing) with another (Treasurys).

An anonymous reader replied to de Rugy that an asset bubble is not the same thing as a rise in the general price level, and that the money supply – properly understood – has not, in fact, dramatically increased because the money multiplier remains low.  In other words, feel free to worry about asset bubbles but not inflation.

We assumed that we weren’t the only ones fascinated by this puzzle, and turned to one of our personal favorite thinkers to help solve it:  Will Harrell, founding partner of Capco Asset Management here in Tampa.  Will’s email response, below, qualifies him as Navigating Venture’s first guest blogger.  (We also link to Will’s thoughts on the topic of risk here.)

I too am riveted by the problem.  By coincidence, I was reading a chapter of Friedman last night where he provides a bunch of proof for his “inflation is always and everywhere a monetary phenomenon.”  Incredibly compelling, example after example, growth of money supply tracking closely with inflation over decades, country after country.

I am the first to admit I don’t fully understand the mechanics on this issue, and it would be hard to say inflation is breaking out.  But I am unwilling to believe that an agency of government has figured out (1) how to successfully fix prices (interest rates) without screwing up supply and/or demand; or (2) some simple new trick that dispenses with Friedman’s armada of historical examples.

How do these mechanics work anyway?  The Fed pays a rate that crowds out private demand – so where does that newly created cash interest payment go?  Either into the money supply, or back to the Fed, for more compounding, ie still more artificially created money supply.  How do we get out of that happy loop?

And the solution of the Fed dumping some of their 500 B in treasuries and 1250 B in mortgages – how do they get 100 cents on the dollar back, when they were the marginal bidder that drove them to that price to begin with?  Last year the Fed wasn’t in the market for mortgages – it was the market for mortgages – who are they going to sell a bunch of 5% coupons to?   To make matters worse, I suspect that most of us who refi’d last year will NEVER give up those rates, so the expected duration of the bonds should be higher than normal, and therefore the decline in price relative to a given increase in interest rates should be higher than normal.

The CPI as a measurement has a litany of failings – here’s another one: if many businesses are getting more efficient at what they produce (and they certainly are, and have been), shouldn’t the inflation baseline be negative rather than zero?  In that case, maybe a 2% CPI could actually imply 4% (or whatever) inflation.

The failure of bond prices to anticipate inflation also mystifies me.  I could certainly be wrong about inflation, but it’s at least possible the bond market is – current bond prices don’t seem to accept even the possibility that inflation will average over the next 30 years even the 3% that we all have come to consider “normal.”  Of course, it’s possible that 500 B of Fed purchases had an impact – and that folks who might otherwise have bought mortgages were pushed by the Fed’s 1250 B of buying there, into buying treasuries.

UPDATE 5/27/10

A contrarian view from In a debate between European monetarists using an unpublished monetary measure (M3) and traditional Keynesians, who can you trust…

The M3 figures – which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance – began shrinking last summer. The pace has since quickened.

“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.

The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.

The US authorities have an entirely different explanation for the failure of stimulus measures to gain full traction. They are opting instead for yet further doses of Keynesian spending, despite warnings from the IMF that the gross public debt of the US will reach 97pc of GDP next year and 110pc by 2015.

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