Nobel laureate Paul Krugman took a victory lap on the pages of The New York Times in front of all who warned of impending runaway inflation from the Fed’s massive monetary expansion. He did more than pronounce them wrong. He (a) labeled their analyses “unprofessional derp,” (b) identified himself as one of a few who “correctly predicted” the Fed was not causing runaway inflation, and (c) identified the Keynesian liquidity trap as the culprit that has kept inflation subdued.
With all due respect to Professor Krugman, his pronouncements are clever and misleading. This is an apt characterization given the tone of his victory lap. His pejorative use of “Austrian types” and lumping “the Glenn Beck/Ron Paul frothing-at-the-mouth Austrian types” with monetarists in a giant homogenous blob of “unprofessional” subscribers of “right-wing ideology,” mirrors his conflation of consumer price inflation and the Austrian concept of inflation.
Ludwig von Mises pointed out that newly printed money is not equally distributed to all members of society. It gets credited to the bank accounts of government and banks first. It then flows to defense contractors who sell bombs and boats to the Department of Defense, or it flows to the investor-class who borrow to leverage investments in stock, real estate, or bitcoin. Hence, massive increases in the monetary base inflate stocks, homes, and bitcoin well before it inflates consumer prices.
Stock, home, and bitcoin prices are graphed with the monetary base below. The monetary base’s correlation with the S&P 500 and with Bitcoin are very strong. The correlation between home prices and the monetary base is strong prior to 2008 and after 2012.
Why Inflation Has Been Contained: Interest on Reserves
Asset price inflation could have been much worse during the post-crisis recovery. It has been somewhat contained but not by a Keynesian liquidity trap. A liquidity trap is the situation where the supply of reserves has increased to such an extent that it intersects the section of demand that has flattened at just above zero. The trap implies that the federal funds rate cannot fall below zero. The problem with this thinking is that it assumes investment and savings decisions are based on nominal rates, not real rates.
Since negative real rates are not uncommon and central banks in Europe and Japan have pushed their equivalent of the federal funds rate below zero, some other factor is creating the mountain of excess reserves shown in the chart below. This chart below implicates the Fed’s latest monetary tool, interest on reserves (IOR), as the culprit. IORs implementation in October 2008 is marked by the vertical black line in the chart below.
Although IOR was adopted in 2006, it was supposed to stay in the tool shed until late 2011. With stock and housing markets quaking in 2008, Congress gave the Fed the tool in October of that year. Before the Fed began using it, excess reserves were all but zero. In the seven years since its rollout, excess reserves exploded to $2.7 trillion in 2015.
The huge jumps in excess reserves from points 1 to 2, 3 to 4, and 5 to 6 show how three bouts of Quantitative Easing (QE), labeled QE1, QE2, and QE3 in the chart above, affected excess reserves. During QE1, excess reserves increased by $1 trillion from point 1 to point 2. This is less than the $1.45 trillion in QE1 purchases because the Fed bought Government-Sponsored Enterprise obligations (GSE), Mortgage Backed Securities (MBS) and Treasuries from not just banks. From points 3 to 4, excess reserves increased by $0.6 trillion, the value of the Treasuries the Fed purchased during QE2. Two years of QE3, which ended in October 2014, increased excess reserves by $1.2 trillion from point 5 to point 6.
In the days prior to IOR, excess reserves were all but zero. Banks loaned extra reserves to consumers and businesses. Although the Fed could lower the federal funds rate by buying Treasuries from banks or raise it by selling Treasuries to banks, the manipulated market cleared, resulting in no excess demand or supply.
What Happened with QE1 and IOR
In October 2008, the federal funds rate was 1% and the discount rate was 25 basis points higher. Without IOR, the Fed’s QE1 purchases were large enough to potentially push the federal funds rate below zero.
To protect against a negative federal funds rate, the Fed used IOR as a binding price floor to induce a liquidity trap, and banks preferred lending to the Fed at the IOR rate to lending to other banks at a negative federal funds rate.
IOR and the minimum wage rate are examples of price floors that create unemployment. In the case of IOR, we’re talking about unemployed reserves. Since these new reserves are not being loaned to consumers and businesses, they are unemployed and the ratio of this value and total reserves is the unemployment rate of reserves.
If the Fed sets the IOR rate below zero, some unemployed reserves will flow into the economy. If the Fed repealed IOR tomorrow morning, unemployed reserves would flood into the economy and the federal funds rate would decline. This implies the federal funds market is not in a Keynesian liquidity trap.
After QE3 ended in late 2014, excess reserves began a downward trend that lies within the long yellow bar in the FRED chart above. After it declined to $2.3 trillion, the chart below reports that the Fed raised the IOR rate in small increments from 0.25% to 1.5%. A Keynesian liquidity trap is hard to sell when the interest rate is 1.5% and excess reserves exceed $2 trillion.
An acceleration in economic growth signals banks to start making more loans. As banks make more loans, more excess reserves are converted into demand deposits. The yellow areas in the first FRED chart show excess reserves leaking out of banks between QE. This leakage accelerates in economic growth, which is graphed with the IOR rate above. This chart shows that the Fed is raising the IOR rate so that it keeps up with economic growth. Doing this slows excess reserves flowing into the economy. If the Fed fails to do this, assuming an M1 multiplier of 1, bank lending could convert the $2.6 trillion in excess reserves into M1. Since an increase of that size represents a 72% increase in M1 from its current $3.6 trillion stock, under the Quantity Theory of Money, consumer price inflation could reach 72%.
Prior to the financial crisis, monetary actions like QE were known as monetizing government debt because central banks used printed money to buy government bonds. In the past, monetizing ended in hyperinflations in Venezuela, Zimbabwe, Yugoslavia, and World War era European nations. This history explains why economists and investors have worried about runaway consumer price inflation. However, unlike past debt monetizing, today’s central bankers can induce liquidity traps by paying interest on reserves to restrain asset and consumer price inflation.
Other Central Banks Have Been Helpful
Relative to other central banks, the Fed’s inflation fight is less difficult. The Fed’s QE was accompanied by QE in other nations. If QE had only been tried in the US, the dollar would have struggled to keep its title as a least worst currency. Despite worries over the dollar, it maintained its reserve status. If it had lost this status, its worldwide demand would have collapsed, and U.S. markets would have been flooded with dollars. Globalization keeps consumer prices low by intensifying the competition between firms located here and abroad. Advances in technology reduce the production and distribution costs that push down consumer prices.
To keep the massive monetary stimulus that is inflating asset prices from doing the same to consumer prices, the Fed will need to throttle the conversion of excess reserves into demand deposits by raising the IOR rate. However, this could squeeze short-term and long-term rates, invert the yield curve, and trigger recession.
If the Fed chooses to keep the IOR rate at 1.5% and the economy continues to pick up steam, due in part to tax reform and regulation rollback, bankers will lend unemployed reserves to consumers and firms. This could set the stage for an encore performance of 1970s-style inflation.
The Fed is between a rock and a hard place. It is damned if it normalizes rates and is damned if it does not. If it does not, it will after its massive monetary expansion, which has inflated asset prices, begins to inflate consumer prices. When the Fed finally normalizes rates, asset prices will collapse, negative returns on heavily leveraged asset will be realized, leveraged investments will be underwater, loan defaults will rise, asset bubbles will pop, and the boom will bust.
