Inflation: Neither Dead Nor Alive…

Banks aren't lending, consumers aren't what?

May 20, 2011

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525200_blue_balloonWith all the quantitative easing, and all the increase in the U.S. debt, many are worried that inflation has to be around the corner. Of course, saltwater economists – those university economists ensconced on either coast – are quick to give a neo-Keynesian response: aggregate demand has fallen off a cliff, so government spending has to push the economy back towards its long-term capacity.

Freshwater economists – mostly monetarists – disagree, thinking that  government spending, on the whole, doesn’t add to aggregate demand, but simply shifts it around. On the other hand, recessions result from mixed signals in the marketplace, usually the consequence of an exogenous shock, like technology, according Paul Krugman, himself a “saltwater economist.” In this view, both fiscal and monetary policy are ineffective.

Whatever the theoretical controversies, certainly some  economists are expecting a pickup in inflation. And, in various commodities, there has been an inflationary impact – food and fuel for example. But these lie outside the core measure of inflation. Arguably, they are global movements over which few central banks have little control. But they can still be problematic.

At issue is that “a rise in inflation expectations would provide a channel for commodity price increases to pass through to prices in general—as measured by core inflation,” write New York Federal Reserve researchers Robert Rich, Joseph Song and Joseph Tracy. “The pass-through would occur via increased wage pressures and attempts by firms to pass on higher production costs to their customers. In this case, the current gap between headline and core inflation would likely be closed in part by a rise in core inflation. This scenario would be of concern to monetary policymakers; a rise in core inflation would pose a risk to price stability and strengthen the argument for tightening monetary policy. Because monetary policy affects the economy with a lag, policymakers would benefit from early indicators of a possible unanchoring of inflation expectations.”

They pose the question in “Are Rising Commodity Prices Unanchoring Inflation Expectations?” The short answer is no.

They use quarterly survey data from the Philadelphia Fed: “the quarterly SPF asks professional forecasters for point and density forecasts of inflation. The density forecasts take the form of a histogram in which respondents assign a probability to a number of preassigned intervals, or bins, into which inflation might fall.”

The Philadelphia survey suggests a fairly pronounced fall in the probability that inflation will exceed 3%, from 5% in the first quarter of 2010 to less than half that in the first quarter of 2011.

But money supply is different. There are concerns that “printing money” has to have an inflationary effect. Quantitative easing may have the same consequence. In a paper entitled Will the Federal Reserve’s Asset Purchases Lead to Higher Inflation?, New York Fed researcher Jamie McAndrews  says the fact that the Fed is now paying interest on bank reserves changes the picture.

“There are three parts to the argument that Fed asset purchases will lead to much higher inflation,” he notes. “First, there is the connection between Fed asset purchases and reserves. When the Fed buys assets from the public, it pays for them by electronically crediting banks’ accounts at the Fed with reserves. Second, there is a connection between reserves and money growth. When banks’ reserve balances increase, they can use these additional reserves to make more loans to households and businesses—an outcome that can lead to further growth in the broad money supply in the economy. Third, there is a connection between higher credit and money growth and inflation. For example, excessive credit expansion can bring on higher money growth, excess demand pressures, and overheating in the economy, which in turn can raise inflation expectations and increase the inflation rate.”

So far, it hasn’t worked out that way. That’s because the banks don’t have the same incentive to lend as they did before. Instead, McAndrews explains, “the introduction of interest on reserves has altered the linkage between reserves and money growth. Before banks were eligible to earn interest on their reserve balances, they had strong incentives to avoid holding ‘excess reserves’—reserves in excess of the amount they are required to hold by regulation. High levels of excess reserves in the old regime would be expected to generate a high growth rate of loans, and consequently high money growth whenever the banks’ risk-adjusted expected return on loans was positive.”

Net, net if the banks aren’t lending, then consumers aren’t buying and businesses aren’t hiring. It’s not clear where to start in this circle of effects – which is why few would consider macroeconomics a science.

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