Exit Strategy: Can The Fed Stop Inflation?

By Jeff Harding.

Dr. Frank Shostak is Chief Economist for MF Global, the former trading arm of Man Financial, the world’s largest hedge fund. Man spun off MF Global as a stand-alone company. I believe he is the best (Austrian school) economist out there in applied economics because he makes his living prognosticating for a commercial investment firm.

I am republishing in its entirety his most recent article, “Is the Fed’s Pumping Inflationary?” from the Mises Institute site where his articles appear. It is a very important article because he believes that (1) we will see substantial inflation, and that (2) “real savings” formation is being eroded which will inhibit economic growth. Regular readers will find this material familiar.

Dr. Shostak’s writing is very clear but it is highly condensed which makes careful reading a necessity. I am adding a synopsis to make it more understandable to those not familiar with Austrian theory. I have also italicized some of this key ideas. This makes this a fairly long article, but it’s rewarding, so please bear with me.

Synopsis

The Fed has a difficult task. It flooded the financial system with credit in order to prevent what it perceived to be world financial collapse. While it believes that its efforts have succeeded, it now has to contend with the threat that this ocean of money and credit it created will result in massive inflation.

Money supply has increased 14% YoY as of August of this year. There has been a substantial amount of reserves piling up in bank balance sheets as they find themselves reluctant to lend the money because of perceived risk and new reserve requirements. It is obvious that the Fed’s attempt to stimulate business activity is not working.

The Fed tries to control the amount of money and credit in the system by setting interest rates which they believe will cause the economy to grow or contract. This is set by the Federal Funds rate. When the Fed tightens rates it sells assets it holds to banks and sops up cash and reduced the money supply, thus raising interest rates. It buys assets (Treasury debt) when it wishes to lower interest rates. Its balance sheet inhibits its ability to set target rates because if they push or pull too much, they will affect the Fed Funds target rate which upsets their monetary policy.

In order to get around this, the Fed has come up with the idea that they will pay banks interest on their excess reserves. This way, they believe they can keep their interest rate target intact yet sop up the cash in the system or at least prevent bank reserves from being lent out to flood the system with cash and cause inflation. In essence they think they are cutting the tie between interest rates and monetary expansion.

If only it were that simple.

Dr. Shostak skewers this concept. First, if the Fed believes it is not creating money by expanding the money supply because the banks are sitting on reserves, they are dead wrong. All things being equal, in order to keep the interest rate at the target rate, the Fed has to create money to keep interest rates from going up. When banks lend money they need cash so they sell some assets (such as Treasury bills) that comprise their excess reserves to fund the loan. This cash will end up in bank accounts eventually which increases the money supply. Unless the Fed increases the money supply, interest rates will go up, thus upsetting the Fed’s target rate of interest. Thus this huge pool of reserves created by creating money (i.e., “printing” money) is an inflationary time bomb.

Secondly, paying interest on bank reserves will not prevent banks from lending to customers. It’s pretty obvious that banks know they can make more on a commercial loan than with the Fed so they have every incentive to lend. Also, they are in the business of lending and if they don’t take care of their customers at a point when other banks are willing to do so, they will lose their customer base.

Thus, there is nothing really stopping this new money from working its way into the economy and causing inflation. Shostak sees this as a recipe for disaster, threatening to destabilize the entire economy. While it’s difficult to predict when this cash will work its way into the economy, when banks’ balance sheets are repaired and the mass of debt created during the boom is more or less liquidated, there is nothing to stop banks from lending.

Shostak points then to the most important aspect of all this and that is the inhibition of the formation of real savings. “Real savings” is primarily an Austrian theory concept of what savings and capital really are. It’s not money. Real savings are consumer goods produced by a manufacturer that are not sold or consumed. For example, the blacksmith makes 10 hammers, sells 6, and keeps 4 for the future. Perhaps he will trade them for a new bellows to increase production. In more modern times the 4 saved hammers was replaced by commodity money such as gold. But the “real savings” were the 4 hammers, not the pieces of gold. To further understand this concept, please see: Shostak, “What is the Condition of U.S. Savings?

If the gold is replaced by paper dollars as we have today, then the printing of dollars doesn’t create wealth, only more paper. Only real savings is wealth. But what deflated dollars and low interest rates does to real savings is distort the role of interest rates by sending a signal to producers to produce even if there are no real savings, no real wealth.

That is what Shostak believes is happening now. He thinks that real savings are being wasted or not being created. Inflation causes people to consume, not save. Today, while consumer savings are increasing, he believes that these savings are not necessarily real wealth and the lack of real savings will jeopardize any recovery and slow economic growth.


Is the Fed’s Pumping Inflationary?

Mises Daily by Frank Shostak | Posted on 9/16/2009 12:00:00 AM

Given the recent, massive increase in commercial banks’ excess reserves, many commentators are of the view that banks will sooner or later start employing these reserves in lending and thus cause an increase in the inflation rate.

Even former Federal Reserve Chairman Alan Greenspan is alarmed by the massive pumping by the Fed and other central banks. Speaking via satellite to a conference in Mumbai on September 8, 2009, Greenspan said that central banks need to defuse the large increases in their assets.

He stated that failing to shrink central-bank balance sheets could lead to very high price inflation: “I am not talking 3–5 per cent inflation; I am talking double-digit inflation in the US.”

In August 2008, excess reserves stood at $1.9 billion. At the end of August 2009, excess reserves stood at almost $800 billion. By early September 2009, they had reached $823 billion.

Some other commentators hold that banks’ decision to sit on their massive surplus cash rather than lend it out raises the likelihood that the Fed’s loose monetary policy remains ineffective. They argue that if the policy had worked, banks would have used the pumped reserves to make loans by now.

… Continue reading Exit Strategy: Can The Fed Stop Inflation?

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Credit Is Shrinking?

By Jeff Harding.

The esteemed Ambrose Evans-Pritchard of UK’s Telegraph makes the unstartling announcement that U.S. bank credit has been shrinking for the past three months at a  rate (14%) that has not been witnessed since the 1930s.

Professor Tim Congdon from International Monetary Research said US bank loans have fallen at an [...]

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Bank Liquidity Report

By Jeff Harding

Here is David Rosenberg, chief economist and strategist for Gluskin Sheff on bank liquidity. Rosenberg was formerly the chief economist for Merrill Lynch. He called the Crash and is a perceptive guy. I am reprinting this to show you that I am not the only one talking about deflation.

This is [...]

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Inflation or Deflation?

By Jeff Harding

I received an interesting comment to my Mr. Sunshine article from Hans Palmstierna at Saving Capitalism. I suggested that we will see more deflation before we see inflation. Hans said:

I would argue that the “nominal” bottom is soon here. With the money now flowing at full speed (M1 at around 20% YoY growth) from every crack in the Federal Reserve, it should soon be impossible for the economy to contract in nominal terms. This doesn’t count for unemployment, of course, which may still rise for quite a while yet.

The only thing that can stop the “nominal” bottom is of course Bernanke slamming the brakes, but that doesn’t seem very likely now does it. Or possibly consumers growing wise and starting to save so much that they outdo the government spending – this would probably produce a L-shaped recession.

Here’s my response.

There is no question that M1 and related monetary components are expanding. Just looking at the Fed balance sheet, it has expanded dramatically, which means it is injecting money into the banking system.

Courtesy News N' Economics: Rebecca Wilder

The chart shows what has happened since last September. The chart estimates what other commitments the Fed has made through 2010.

However there are good arguments that this money has not yet hit the economy full force which leaves room for deflation. Deflation is just a downward revaluation of assets in monetary terms. I think we’ll see further asset devaluation in Asset Backed Securities such as securities backed by commercial mortgages, credit card debt, auto loans, and student debt.

I am not saying that we won’t eventually have inflation. There’s too much money waiting to hit the economy for inflation to not happen. I use the Austrian definition of inflation which is an increase in the supply of cash and credit by a central bank and a subsequent lack of demand for money. Or, to say it another way, printing dollars causes people to shed dollars causing an increased demand for goods, which results in higher prices. Prices going up is an effect of inflation, not inflation itself. Of course increasing prices is how we can tell we have inflation. The hallmark of inflation is that all prices increase, not just certain prices as a result of supply and demand factors in the marketplace.

It certainly appears that the Fed in increasing the supply of money. Money base shot skyward as the chart below shows. … Continue reading Inflation or Deflation?

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